Baker Adhesive Case Study

Abstract

Currency exposures are big risks for companies that engage in international trades across their borders. A company is exposed to currency risk when revenue earned abroad is converted into the money of the domestic country, and when payables are converted from the domestic currency to the foreign currency. Hedging enables international traders or businesses to manage their exposure to currency risk. When a firm hedges its currency risk it eliminates the variance in expected cash flows from the trade that may arise as a result of unexpected changes in the exchange rates.

Baker Adhesive just made it first foray into the international market from its sales to Novo, a Brazilian toy manufacturer. The first order has been profitable; however, the second order that is 50% larger than the first order does not seem profitable due the unforeseen exchange rate changes which would affect its profit margin. Baker Adhesive must strategize on how to deal with the currency risk that is affecting the profitability of its sales. In order to do this, Baker Adhesive must choose out of the hedging options which are; No hedge, hedge in the forward market or to hedge in the money market. With the support from the bank Baker has to decide if it wants to venture or accept the new order since Novo refused to change the price per gallon of the current demand. This study is to find the most profitable undertaking for Baker Adhesive in mitigating the risk on current exchange risk.

Question 1

How profitable is the original sale to Novo once the exchange-rate changes are acknowledged? How might the exchange-rate risk, which affected the value of the order, have been managed? Do not forget to consider possibilities beyond the two hedges introduced in the case.

Answer  

The original sale to Novo at the initial exchange rate stood at 109,081.50 BRL for 1,210 gallons at an exchange rate of 90.15 (BRL). After the exchange, Baker Adhesive was to receive the sum of $50,570.18 at a conversion rate of 0.4636 USD/BRL, which indicates that Baker Adhesive actually received $47,646.80. This resulted to a loss of 2,923.38 on the value of payment from their deal with Novo due to the current change in exchange rates. Deducting the total costs from the inflow, Baker adhesive would get an actual profit of $3,146.80 instead of an expected profit of $6,070.18

To manage this exchange rate risk, Bakers Adhesive has two options, which are;

1. Hedge in the Forward Market

       Baker Adhesive would get a contract from the bank to have a guaranteed exchange rate for the future exchange rate of its currencies (Forward rates). This contract with a specified date, an amount to be exchanged and the rate is given at today’s value, can eliminate the exchange risk  that may arise as a result of currency fluctuations, the fees due to the bank would be built into the rates.

      By securing a forward rate for anticipated future cash flows in Real from its sale to Novo, Baker Adhesive can mitigate any risk that may arise due to currency fluctuations. Furthermore, future inflows from Novo would be converted at a rate known or agreed upon today by Baker and its bankers. Bakers Adhesive’s bank has agreed to offer a forward contract at an exchange rate of 0.4227 USD/BRLs.

1. Hedge in the Money Market

       To hedge in the money market, Baker Adhesive has the option to borrow today in a foreign        currency where the exchange is known at a current spot rate, convert expected future cash flows to current cash flows. Baker adhesive would borrow today in a foreign currency and the amount to be borrowed is dependent on the interest rate in the foreign currency. As given in this case, Baker would need to borrow BRLs against future inflows from Novo whilst putting into consideration that it will cover both the principal and interest on the borrowing.

1. Hedging with options

    Bakers Adhesive Baker Adhesive could manage its exposure by purchasing a put option. Under this hedging technique it would buy an option on BRL 109,081.50 at an “at-the-money” strike price with a negotiable premium cost. According to the contract if exchange rate is above $0.4636/BRL, the company would not exercise the option but would exercise if the expected exchange rate is below at that time. If the currency value depreciated only then the company would exercise the option and sell the option at $0.4636/BRL rate otherwise terminated the contract against the put premium.

Question 2

If Baker agrees to the new Novo sale they should consider hedging the exchange rate risk. The case introduces three possibilities:  

(1) No hedge,  

(2) Hedging using a forward contract, and

(3) Hedging using the money market.  Clearly describe the hedging possibilities in your own words. What exact steps need to be taken by Baker to implement the hedges?

Answer

If Baker Adhesive agrees to the new sale then they should consider the following hedging possibilities, which are

1. No hedge: In case of not hedging, Bakers adhesive would get a future value 69,278$ at a forecast rate of 0.4234 against the BRL and a present value of $67,823 by applying the discount factor on the for 2.1452% to the future value (See Exhibit 2)

1. Hedge in the Forward Market: Should Baker want to hedge their transaction with a forward then, Bakers Adhesive gets a future value of 69,163$ at a forward exchange rate of 0.4227 USD/BRL as agreed in the forward contract with their bankers.  Additionally, Bakers would get a present value of $67,711 at an effective monthly rate of 2.1452% over 3 months as agreed with the bank. (See Exhibit 3).
2. Hedge in the Money Market: If Baker Adhesive chooses to hedge in the money market, the amount to borrow now and for repayment is $67,108. This is calculated by dividing the interest rate of 6.5% from the Brazilian real value of 163,622 and converting the currency using the forecast bid rate of 0.4368 (See Exhibit 4).

Question 3