Foreign Exchange Exposure

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Yankee Dental Systems: Foreign Exchange Exposure

It was the 25th of June. America was getting ready to celebrate Independence Day but George Hutchinson was preoccupied about his company’s future. This summer there was no celebration at Yankee Dental Systems (YDS). On the contrary, he was forced to furlough the entire staff of 100 and close down the New York office until July due to lack of business. Although there was gloom and doom all around the world, triggered by the subprime crisis in the United States in 2007, Hutchinson feared that YDS was hit particularly hard and his hopes for the company’s survival hinged on a quick economic recovery. A silver lining for YDS was that the company had several back orders that still needed to be fulfilled.

Hutchinson was at the office by himself to address administrative issues. At noon, he powered his computer down to head out for lunch with a client. Suddenly, the fax machine started to buzz. When the transmission was complete, he was pleased to find out that Metro Technologies Limited (MTL) of India had just submitted a bid to supply systems and software that he needed to fulfill his orders. The bid was lower than Hutchinson had expected, perhaps because the global economic crisis had impacted software business in India and MTL was eager to get his business. This was excellent news, particularly since Hutchinson was confident about MTL’s ability to deliver quality software in a timely manner. He was expecting two more bids and would make a decision as soon as he received them.

Company Background

Frank Hutchinson, George Hutchinson’s father, started dentistry practice in 1979, four years after graduating from a dentistry college. In those four years, he had worked for another dentist and had developed a good understating of the dentistry business. It took Frank two years to establish his own business. He then encouraged George to pursue a career in dentistry, and help out at the office. However, George found himself interested in sales and marketing and launched a dental supply company in 1985. With a prior exposure to dental business and contacts in the industry, George quickly became successful. In 1990, he changed the company name to Yankee Dental Systems and started to offer high-margin computerized equipment. See Exhibit 1 below for the firm’s sales and income data for the past five years and Exhibit 2 for the most recent annual balance sheet.

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Copyright © 2012 Ameet Padnani

All Rights Reserved

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Exhibit 1 – YDS Sales and Income Data

Year

Sales (USD)

Net Income (USD)

1

4,800,000

(550)

2

6,250,000

1,365,000

3

8,400,900

2,050,000

4

10,000,100

2,466,300

5

8,135,070

1,436,000

Exhibit 2 – YDS Most Recent Annual Balance Sheet

ASSETS

Current Assets:

(USD)

Cash and securities

750,000

Accounts Receivables

1,920,500

Inventories

3,070

Total current assets

2,673,570

Property, Plant, and Equipment, net

3,897,650

Goodwill and intangibles

1,456,090

TOTAL ASSETS

8,027,310

LIABILITIES

Current liabilities:

Bank loans

1,540,000

Accounts payable

1,124,900

Notes payable

184,070

Total current liabilities

2,848,970

Equity and retained earnings

5,178,340

TOTAL LIABILITIES AND EQUITIES

8,027,310

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The MTL Bid

Hutchinson received the remaining two bids the next day. Although both companies were domestic, their bids were higher than MTL’s even with expected currency exposure. He accepted MTL’s bid and decided to hedge the currency risk. He called his banker, Kevin Rogers, at Bank of America and made an appointment for the next business day to discuss foreign currency hedging alternatives.

MTL’s bid was for a total of 100,000,000 Indian rupees and it was valid until July 10. Since the two companies had prior business transactions, YDS was a known party to MTL. Therefore, the vendor did not insist on a letter of credit. The quoted payment terms were as follows:

• 10% (INR 10,000,000) upon acceptance of the quote

• 40% (INR 40,000,000) upon first delivery three months later

• 50% (INR 50,000,000) upon final delivery with advanced features

The Hedging Alternatives

On June 30, Hutchinson wired the initial payment of INR 10,000,000 and visited Bank of America seeking advice on managing the currency exposure on the INR. Rogers, his banker, presented the following alternatives and explained that the best alternative could not be determined in advance; rather the choice of alternative would be a judgment call:

1. Remain unhedged (do nothing)

2. Enter into a forward contract

3. Cover the exposure in the futures market

4. Use foreign currency options

5. Use money markets

1. Remain unhedged – Rogers pointed out that the spot rate on the day the bid was accepted had settled at INR48/USD. Looking at the year-to-date currency rate movements (see Exhibit 3), he expected the INR/USD rate to fluctuate between 44 and

54. He cautioned Hutchinson that although this strategy required no upfront cost and could result in maximum gain, it was also very risky in that unfavorable spot rate movements outside of the expected range could wind up costing Hutchinson a lot more than he had anticipated.

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This assignment is due 3/15/2012 at 5:50 pm

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Exhibit 3 – INR/USD Rate from January to July 1

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2. Enter into a forward contract – This involved buying or selling a predetermined amount of one currency for another at an agreed upon exchange rate at a specified delivery date in the future. Rogers quoted the following INR/USD forward exchange rates:

Delivery

Amount

Exchange Rate

3-months forward

INR 40,000,000

INR46.22/USD- INR47.19/USD

6-months forward

INR 50,000,000

INR45.03/USD- INR45.99/USD

Hutchinson liked the assurance of locking in the exchange rates, but also wondered if that was his best choice because if the dollar strengthened vis-à-vis the rupee over the next six months, he would have to forgo any gains due to the favorable movement. Another drawback of entering into a forward contract was that if MTL was unable to deliver the software on schedule, the forward contracts would still be executed.

3. Cover the exposure in the futures market – To address the drawbacks of the forward market, Rogers suggested working with futures contracts. A futures contract is a standardized obligation to buy or sell a specific amount of the underlying currency on or before the expiration date. Once a position is open, it would have to be closed by taking an offsetting action. Most currency futures contracts are offset on or before they expire at a gain or a loss without physical delivery of the underlying currency. Rogers advised Hutchinson that he would have to open a margin account to trade futures contracts and

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the account will be marked-to-market daily and was subject to margin calls. A glance at his computer screen revealed the following USD/INR quotes on the Dubai Gold and Commodities Exchange (DCGX). See Appendix A for details on the quotes.

Expiry Date

Open

High

Low

Close

PCP1

Volume

Open

Interest

September

216.08

216.25

214.76

215.05

215.75

3,925

1,345

December

221.43

221.88

220.01

220.99

221.10

1,183

452

Rogers made an interesting observation that the expiration dates on the September and December futures contracts coincided with the dates that Hutchinson was expected to make payments. He estimated that the futures contracts would settle in the range of 185 and 230 (at or near the expected spot prices in September and December).

4. Use foreign currency options – A foreign currency options contract would give YDS the right, without creating an obligation, to buy or sell Indian rupees on or before a future date. A European-style option can only be exercised on the expiration date, whereas an American style option can be exercised anytime before the expiration date.

If, as a buyer of the option, YDS chose to exercise the option, the writer of the option had an obligation to sell or buy the underlying currency. Although YDS could buy standardized exchange-traded contracts, Rogers could also arrange customized over-the-counter (OTC) options. He offered the following quotes on OTC options contracts on the Indian rupee with strike price and premium amounts both represented in USD/INR:

INR 40,000,000 Expiring Sept

INR 50,000,000 Expiring Dec

Strike Price

Call

Put

Call

Put

0.0200

0.00046

0.00080

0.00070

0.00120

0.0208

0.00056

0.00055

0.00080

0.00081

0.0216

0.00066

0.00035

0.00090

0.00037

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1 Previous closing price

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5. Hedge in money markets: – The final alternative Rogers presented to Hutchinson was utilizing money markets. He quoted the following per annum rates, inclusive of all spreads and upfront fees based on the credit rating of YDS.

3-months

6-months

USD Borrowing Rate

10.45%

11.24%

USD Investment Rate

2.09%

2.16%

INR Borrowing Rate

12.50%

13.64%

INR Investment Rate

6.00%

7.10%

Hutchinson liked the idea of the loan since he could use the proceeds to finance working capital, but wondered about the consequences of locking the interest rate. With five alternatives, he started mulling over pros and cons of each to determine the best alternative.

Assumptions

v Assume the weighted average cost of capital of YDS to be 12% and consider the opportunity cost where applicable

v Ignore margin requirements, marked-to-market calculations, transaction costs, and commissions on futures contracts

v YDS will exercise options and not sell them in the OTC market

Student assignment:

v Evaluate and compare all five alternatives describe above

v Describe the best alternative for YDS and explain why

v Clearly state any other assumptions you make. Explanations to clarify the case after it has been graded are not acceptable.

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Expectations

This is a group project and all members of the team are expected to work in a collaborative manner to demonstrate a thorough understating of the case. Your grade on the project is contingent upon the accuracy, analysis, and presentation of your work.

Grading Criteria

Item

Points

Clarity of explanations and presentation

10

Unhedged segment

02

Forward contract hedging

03

Futures contacts hedging

35

Options hedging

25

Money market hedging

25

Total

100

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This assignment is due 3/15/2012 at 5:50 pm

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Appendix A

Dubai Gold and Commodities Exchange Indian

Rupee Futures

http://www.dgcx.ae/Images/FileManager/1583.pdf

http://www.dgcx.ae/content/Home.en.Products.Contract_Specifications.aspx#rupee

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