Boullain Co is based in the Eurozone and manufactures components for agricultural machinery. The company is financed by a combination of debt and equity, having obtained a listing five years ago. In addition to the founder’s equity stake, the shareholders consist of pension funds and other institutional investors. Until recently, sales have been generated exclusively within the Eurozone area but the directors are keen to expand and have identified North America as a key export market. The company recently completed its first sale to a customer based in the United States, although payment will not be received for another six months.
Hedging policy and key stakeholders
At a recent board meeting, Boullain Co’s finance director argued that the expansion into foreign markets creates the need for a formal hedging policy and that shareholder value would be enhanced if this policy was communicated to the company’s other stakeholders. However, Boullain Co’s chief executive officer disagreed with the finance director on the following grounds. First, existing shareholders are already well diversified and would therefore not benefit from additional risk reduction hedging strategies. Second, there is no obvious benefit to shareholder value by communicating the hedging policy to other stakeholders such as debt providers, employees, customers and suppliers. You have been asked to provide a rationale for the finance director’s comments in advance of the next board meeting.
Hedging products
Assume today’s date is 1 March 20X0. Boullain Co is due to receive $18,600,000 from the American customer on 31 August 20X0. The finance director is keen to minimise the company’s exposure to foreign exchange risk and has identified forward contracts, exchange traded futures and options as a way of achieving this objective.
The following quotations have been obtained.
Exchange rates (quoted as €/US$1)
Currency futures (contract size €200,000; exercise price quoted as US$ per €1)
Currency options (contract size €200,000; exercise price quoted as US$ per €1, premium: US cents per €1)
Assume futures and options contracts mature at the month end and that there is no basis risk. The number of contracts to be used should be rounded down to the nearest whole number in calculations. If the full amount cannot be hedged using an exact number of futures or options contracts, the balance is hedged using the forward market.
Margin information
Once the position is open, the euro futures contract outlined above will be marked-to-market on a daily basis. The terms of the contract require Boullain Co to deposit an initial margin of $3,500 per contract with the clearing house. Assume the maintenance margin is equivalent to the initial margin. The tick size on the contract is $0·0001.
Your manager is concerned about the impact of an open futures position on Boullain Co’s cash flow and has asked you to calculate and explain the impact of the following hypothetical changes in the closing settlement price in the first three days of the contract.
Closing settlement prices (US$ per €1)
Required:
(a) Explain the rationale for the policy of hedging Boullain Co’s foreign exchange risk and the potential benefits to shareholder value if that policy is effectively communicated to the company’s key stakeholders.
Rationale for hedging policy
Within the framework of Modigliani and Miller, Boullain Co’s CEO is correct in stating that a company’s hedging policy is irrelevant. In a world without transaction or agency costs, and where markets are efficient and information symmetrical, hedging creates no value if shareholders are well diversified. Shareholder value may even be destroyed if the costs associated with hedging exceed the benefits.
However, in the real world where market imperfections exist, including the transaction costs of bankruptcy and other types of financial distress, hedging protects shareholder value by avoiding the distress costs associated with potentially devastating foreign exchange fluctuations.
Active hedging may also benefit debt-holders by reducing the agency costs of debt. A clearly defined hedging policy acts as a signalling tool between shareholders and debt-holders. In this sense, hedging allows for higher leverage and a lower cost of debt and reduces the need for restrictive covenants.
Communication of policy with stakeholders
Even when foreign exchange risks are hedged, the funding of variation margin payments on exchange traded futures can create financial distress. A well communicated hedging strategy allows debt providers to make informed decisions about Boullain Co’s ability to service its debt.
Agency costs and the risk of financial distress also impact the expected wealth of employees who, unlike shareholders, may not enjoy the risk reduction benefits of a diversified portfolio. A consistent hedging policy reduces the risks faced by employees which may serve to benefit Boullain Co in the form of motivational and productivity improvements.
Customers and suppliers have claims on a company which create shareholder value but are conditional upon Boullain Co’s survival. Suppliers may invest in production systems which create value in the form of lower costs. For customers, these claims reflect promises of quality and after-sales service levels which enable Boullain Co to charge higher prices. In both cases, shareholder value is created as long as the customers and suppliers believe these claims will be honoured. One way of achieving this is by implementing a hedging strategy and communicating it to stakeholders.
In conclusion, management should attempt to communicate the principles underlying its hedging strategy and the benefits to shareholder value in the form of reduced agency and distress costs. In this way, stakeholders can make informed decisions about the potential risks and impact on their expected wealth.
(b) Recommend a hedging strategy for Boullain Co’s foreign currency receipt in six months’ time based on the hedging choices the finance director is considering. Support your recommendation with appropriate discussion and relevant calculations.
Forward contract
$18,600,000 x 0·8729 = €16,235,940
Futures
Buy September € futures
Calculation of futures price
Spot rate (US$/€1) = 1/0·8707 = 1·1485
Predicted futures using spot rate = 1·1422 + ((1·1485 – 1·1422) x 1/7) = 1·1431
Or using futures: 1·1422 + ((1·1449 – 1·1422) x 1/3)) = 1·1431
Number of contracts
Expected receipt = $18,600,000/1·1431 = €16,271,542
Number of contracts = €16,271,542/€200,000 = 81·4, say 81 contracts
Amount underhedged = $18,600,000 – (81 x €200,000 x 1·1431$/€) = $81,780
Receipt at forward rate = $81,780 x 0·8729€/$ = €71,386
Outcome
Options
September € call options
Number of contracts
Payment = $18,600,000/1·1420$/€ = €16,287,215
Number of contracts = €16,287,215/€200,000 = 81·4, say 81 contracts
Premium
Premium = 81 x €200,000 x 0·0077$/€ = $124,740
Translate at spot = $124,740 x 0·8711€/$ = €108,661
Amount underhedged = $18,600,000 – (81 x €200,000 x 1·1420$/€) = $99,600
Receipt at forward rate = $99,600 x 0·8729€/$ = €86,941
Outcome
Recommendation
The forward and futures contracts fix the exchange rate with the futures contract generating a slightly higher euro receipt compared to the forward. However, the futures contract is exposed to basis risk and is marked-to-market daily. The initial margin and variation margins need to be funded and would impact cash flow in the short term.
The option outcome of €16,178,280 provides a worst-case scenario based on the option being exercised. The option premium is expensive which results in a lower receipt if the option is exercised. Unlike the forward and futures contracts, however, the option allows Boullain Co to retain the upside whilst also protecting against the downside risk. Based on the forward and futures markets, the dollar is expected to strengthen and it is therefore unlikely the option would be exercised.
The final hedging choice depends on the board’s attitude to risk. However, assuming there is no default risk associated with the forward contract, this may be the best choice under the circumstances. The board may also wish to consider the possibility of not hedging since the dollar is expected to strengthen.
(c) Calculate and explain the impact of the open futures position on Boullain Co’s US$ cash flow, based on the settlement prices provided.
Marking-to-market
Initial margin = maintenance margin = $3,500 x 81 = $283,500
1 March:
((1·1410 – 1·1422)/0·0001) x $20 x 81 = $19,440 loss
Maintenance margin is 100% of initial margin:
Therefore variation margin = $19,440
2 March:
((1·1418 – 1·1410)/0·0001) x $20 x 81 = $12,960 profit
3 March:
((1·1433 – 1·1418)/0·0001) x $20 x 81 = $24,300 profit
In order to reduce counter-party risk, Boullain Co deposits the initial margin of $283,500 with the clearing house when the futures position is opened. The notional profit or loss at each day’s closing settlement price is added to or subtracted from the margin account balance. If the margin account balance falls below the level of the maintenance margin, Boullain Co is required to deposit additional funds to top up the margin account.
Boullain Co makes a notional loss at the end of the first day and would therefore pay a variation margin to return the margin account to the level of the specified maintenance margin. Since Boullain Co makes a notional profit on the subsequent two days, the amount in the margin account will be greater than the specified maintenance margin and no variation margin is required. The profit on each of those days may be withdrawn in cash.