Vanguard Security Corporation: Foreign Exchange Hedging Dilemma

Transcription

1 A F. John Mathis Paul G. Keat Vanguard Security Corporation: Foreign Exchange Hedging Dilemma A late spring day was dawning as Peter Levin, Vanguard Security Corporation s treasurer, arrived at the office to meet with his team to finalize a key decision. Vanguard Security was involved in a large sale to an American buyer, and Peter had to decide which of several foreign exchange hedging strategies was appropriate, if any. Sally Smith, Peter s bank relationship manager, and the bank s chief foreign exchange advisor had provided him with several possibilities. They were due in about an hour, giving Peter time to first meet with his team to consider which options would be best for the company. The urgency for the meeting was due to an unanticipated drop in currency exchange rates, which had already cost VSC a large sum of money. Company Background and the Transaction Vanguard Security Corporation (VSC), a European corporation headquartered in Portugal, was founded in the early 1990s as a financial security provider for corporations with exposure to Internet fraud. Its main clients had been major commercial banks in Europe, but now it had an opportunity to enter the U.S. market. VSC was primarily a computer software and hardware systems company with a strong reputation in the financial services industry as one of the leading providers as well as one of the most expensive providers. VSC had experienced rapid expansion in revenues and profits during its early growth stages. However, increased competition from several companies in Asia had cut into its market and, as a result, revenues and profitability had deteriorated during the past several years. Many of VSC s top managers were still with the company, but when the company went public just prior to the bursting of the tech bubble in late 1999, several founding owners cashed out and new management was recruited. Subsequently, on several occasions VSC had been forced to cut its prices and historically high margins in order to retain customers. To remain competitive, the company had also begun to acquire long-term debt to fund research and build production capacity by purchasing new equipment. Because several private equity companies had been showing interest in VSC, senior management was increasingly concerned that they might be replaced. The U.S. was viewed as a possible new market for VSC to deploy some of its existing technology and build revenue by developing a new customer base. Barely a week ago, Peter had been scrambling to finalize VSC s year-end income statement and balance sheet (Figure 1). The American company, based in Boston, had insisted that Peter submit VSC s year-end financials before allowing it to bid for the project, because they wanted to make sure that if VSC won the bid, they would have the financial resources to complete the project on time. This had delayed VSC s bid on the new project. Copyright 2008 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professors F. John Mathis and Paul G. Keat for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

2 Figure 1 Sales and Income Statement The Bid Year Ended Dec. 31 Sales Euros mil. Net Income Euros mil Balance Sheet (2008) Assets Euros mil. Current assets: Cash and securities 2.1 Accounts receivable Inventories 20.8 Total current assets Property, plant and equipment Cost Less: Accumulated depreciation (106.0) Goodwill and intangibles TOTAL ASSETS Liabilities Current liabilities Bank loans Accounts payable 33.4 Notes payable 75.6 Long-term liabilities Debt TOTAL LIABILITIES Equity and retained earnings TOTAL LIABILITIES AND EQUITY VSC had bid on a rather large project in the United States which, if accepted, could help reverse a declining net income trend. The bid was for the design, construction, installation, testing, and provision of a six-year service and warranty agreement. If the company accepted VSC s bid, which included a 10 percent down payment upon acceptance, the contract specified that the first part of the project must be completed within six months. The warranty would be paid in equal annual installments over the life of the contract at the beginning of each year. Most of the components of the bid would have to be built specifically to meet American standards and be able to interface with the system currently in use by the U.S. finance company. Also under the terms of the agreement, VSC would have to secure a performance bond from a third-party vendor if awarded the bid. The performance bond would cost 0.35 percent of the outstanding contract value according to Sally Smith, VSC s bank relationship manager. 2 A

3 The bid was tendered on April 1, and on May 15, VSC was notified that they had been awarded the contract (Figure 2). In accordance with the terms of the contract, the U.S. company had ed and faxed a letter of acceptance. The U.S. company also had notified VSC that it would be wiring 10 percent of the purchase price, also as stipulated in the contract, on the morning of May 16. Figure 2 Bid Preparation Euro mil. Design 3.7 Materials 68.9 Labor & installation 6.9 Shipping 1.2 Direct overhead 3.4 Allocation of indirect overhead 1.7 Service and warranty agreement (6 years) 12.0 Subtotal 97.8 Markup (12%) 11.7 Total Bid in mil Conversion to US$ at April 1 spot rate of $ = 1 Total Bid in US$ US$ The remainder of the agreed price was due at the time the system was installed, tested, and certified operational by the American company. The target date for VSC to fulfill the terms of the contract and be paid was November 17, six months from the day the down payment was received. The VSC chief operating officer had verified with his suppliers that there would be no problems meeting this delivery schedule for hardware, although the product was not currently in inventory. Similarly, the software would have to be specially developed, but, again, no problems were expected in terms of meeting the agreed-upon delivery schedule. On May 16, Peter Levin verified that VSC had received a funds transfer of US$ million. The remaining outstanding balance of US$ million ($ million less the service agreement of about $18 million) was due on November 17, assuming all the terms and conditions of the contract were satisfied. In preparing the bid, VSC had allowed for a modest markup of 12 percent, which is less than what it would have charged normally. However, VSC was concerned about its declining net income and wanted to make sure it had a competitively priced bid, including the need to build new components. VSC knew that the quality of its product in the European market was recognized as outstanding. But because the company was not well known in the U.S., VSC realized that it would have to earn its outstanding brand recognition by proving it could successfully adapt its systems to American standards. Relationship between the U.S. Dollar and the Euro On May 16, when VSC s bank received the wire transfer deposit of US$ million, it had to be converted into euros before VSC could begin to use the funds. Between April 1, when the bid was tendered, and May 16, when funds were received by VSC, the euro had depreciated by about 0.74 percent relative to U.S. currency. The exchange rate was now $ = 1. Because of the rate change between April 1 and May 15, VSC received just 10,869,389 million on May 16. This represented a loss of 80,611, due entirely to the drop in the exchange rate, something which VSC had not anticipated. VSC now realized that it had to focus on the value of the final payment of US$ million expected on November 17. The change in the value of the U.S. dollar relative to the euro had resulted because the U.S. Federal Reserve Board of Governors had eased monetary policy and lowered interest rates by another 50 basis points. In contrast, the European Union had decided not to follow this U.S. rate change and had kept its interest rates stable, thus making holding euros less attractive. Furthermore, in the period ahead, inflation and interest rates in Europe were expected to rise, while the opposite was expected to happen in the United States. A

4 Peter knew he had to act to protect the company from adverse exchange rate changes between mid-may and mid-november but, what? He had examined the movement of the US$/ exchange rate over the previous several months before issuing the tender bid for the project, as reflected in the data in Figure 3. Figure 3 The data reflected a significant degree of volatility, with the U.S. dollar both appreciating and depreciating relative to the euro. He saw no reason for this pattern to change. A particularly disconcerting characteristic of the data was that, at times, the U.S. dollar would depreciate consistently against the euro over a period of several months. This meant that he could lose a significant share of the profit built in to his pricing of the project. He had to find a solution because he could not afford to take this risk. The decision would be made at that morning s meeting, after examining the various options and the economic outlook. The Decision Menu: Foreign Currency Exposure Management Alternatives The evaluation of expected macroeconomic developments in the United States and Europe confirmed Peter s concerns about a possible depreciation of the U.S. dollar relative to the euro. It was at this point that the bank s relationship manager for VSC arrived, accompanied by the bank s chief foreign exchange risk management executive. They explained that a foreign currency hedge would be an appropriate response to the foreign exchange risk faced by VSC. Since VSC had an outstanding euro contract, or receivable, a hedge could be accomplished by any one of the following techniques: 1. Forward Currency Contract A forward foreign exchange contract would involve buying a contract from the bank committing VSC to deliver the exact amount of U.S dollars they would receive on November 17 from the American company if they performed on their agreement with them. The forward contract, if agreed to at the meeting, would deliver U.S. dollars to VSC on November 17 at today s quoted sixmonth forward rate of 1 = US$ Foreign Currency Futures Contract Exchange Rates Month End of Period /US$ End of Period US$/ April May June July August September October November December January February March A futures contact for euros is a standardized agreement to purchase or sell a specific amount of currency on a specific date. A euro futures contract, usually arranged through the Chicago Mercantile Exchange in this case for $125,000, could be purchased to buy or sell currency at the end of March, June, September, and/or December. The broker s fee for the purchase was US$ The buyer or seller of the contract had to take or make delivery of the currency, and the position could only be eliminated if the futures contract was offset. The September futures price on that spring day was 1 = US$1.4635, and the December contract price was 1 = US$ A

5 3. Foreign Currency Options This currency hedging instrument would give VSC the right to either purchase (call) or sell (put) a currency at a specified price on a specific date in the future if it is a European style option, or at anytime in the future if it is an American style option. The purchaser of an option has the right, but not the obligation, to exercise the option. The purchaser can either receive the currency (call) or deliver the currency (put) if choosing to exercise the option, or allow the option to expire unexercised. The seller, or writer, of an option, on the other hand, must stand ready to fulfill an option obligation and surrender the currency on demand (call) or receive the currency on demand (put). Since VSC had a contract to be paid in U.S. dollars on November 17, it could hedge this foreign currency exposure by buying a U.S. dollar put option or writing a U.S. dollar call option. Buying a U.S. dollar put option would protect VSC from any unfavorable downward movement in the U.S. dollar exchange rate relative to the euro. Writing a U.S. dollar call option would allow VSC to benefit if there was little or no change in the exchange rate of the U.S. dollar against the euro. The purchase of a U.S dollar option would require an option premium to be paid at the time the contract was issued. Currently, the 180-day currency option premium on a strike price (or exercise price) of 1 = US$ was: US$ /euro for a call premium, and US$0.0215/euro for a put premium. If VSC wrote a call option, it would receive the premium. 4. Tunnel Forwards One alternative for VSC, which would not cost the company anything up front but would give it some exchange rate protection, was a tunnel forward. This was a contractual agreement identifying a specific exchange rate band or defined range within which VSC would have to exchange currencies on a specific future date. The upper and lower limits of the range are like settlement rates if the actual exchange rate exceeds the limits of the range of the tunnel. Miller, VSC s banker, indicated that such a zero cost tunnel could be established with the strike on the euro put set at (1 = US$1.4075) and the strike on the euro call set at (1 = US$1.5556). 5. Foreign Currency Loan This product would create a U.S. dollar obligation 180 days in the future if VSC borrowed U.S. dollars from the bank at today s meeting and then used the proceeds, which would immediately be converted to euros, to help finance the completion of the contract. VSC would then repay the principal and interest on the euro loan on November 17 with the euros received from completing the contract. Any exchange rate gains or losses on the receivable due to a change in the value of the US$/euro exchange rate would be offset by matching losses or gains on the US$/euro value of the loan. In his role as chief foreign exchange advisor, the banker believed that a 180-day loan in U.S. dollars could be made today at a rate of 2.0 percent above the U.S. dollar prime rate of 6.00 percent plus an arrangement fee of percent. The comparable euro interest rate was at 5.50 percent with VSC paying a spread of 1.85 percent over prime in the euro market which was not much different from the spread in the U.S. 6. Presale of Foreign Contract Peter also knew that it was possible to pre-sell the foreign contract, or receivable, at a discount as an alternative method of raising funds to help VSC finance the completion of the project. This technique would also provide protection against a possible change in the value of the euro relative to the U.S. dollar. The discount, or interest rate, for the pre-sale was fixed for the 180-day period at US$ LIBOR (London Inter-Bank Offered Rate), currently at 4.15 percent plus a credit risk spread for VSC of 1.8 percent. The arrangement fee for setting up this transaction was a flat upfront fee of 0.5 percent. The current euro six-month LIBOR was 4.35 percent. A

6 Regarding the longer-term 6-year service agreement, VSC s bankers recommended exploring the following options: check if VSC had any offsetting foreign currency payments to match the receivable, or determine if it made sense to use back-to-back or parallel loan arrangements to offset the expected U.S. dollar receivable. Current Economic Performance: Europe and United States Economic activity was finally gaining momentum in Europe, following a long period of sub-par performance, while, in contrast, the U.S. economy, which had been growing at a healthy pace, was beginning to show signs of weakness. Neither region had had serious inflation problems for some time. Unemployment continued to be more of a problem in Europe than in the United States. However, in the period ahead, inflation and interest rates in Europe were expected to rise, while the opposite was happening in the United States. The U.S. economic outlook had been revised downward from earlier forecasts to about 2.5 percent, which was a slight improvement over the previous year s performance. The result would be a slight rise in unemployment and further easing in upward pressure on prices. The U.S. balance of payments was stabilizing following a brief period of improvement as export growth accelerated. Meanwhile, the U.S. dollar, which had been volatile sporadically relative to the euro, was now showing signs of depreciating, reflecting weakening confidence triggered by the subprime banking crisis, uncertainties about U.S. policy management, and an upcoming election which would bring about a change in leadership. U.S. monetary policy had been eased and is supportive towards restimulating growth. Earlier this year, interest rates began to decline as the Fed s policy shifted to ease credit conditions. In contrast, Europe has experienced relative stability in money supply growth and interest rates. Even so, Europe continues to face digestion problems politically and economically absorbing all the newly entering countries into the euro zone. 6 A

7 Figure 4 Macroeconomic Data Year Year Year Year Year Year Year Real GDP Growth U.S. % Real GDP Growth euro % Inflation CPI U.S. % Inflation CPI euro % Unemployment U.S. % of labor force Unemployment euro % of labor force U.S. Gov t Deficit % GDP % Euro Gov t deficit % GDP % U.S. Money Supply Growth % M Euro Money Supply Growth % M U.S. Short-term Interest Rates % Euro Short-term Interest Rates% U.S. Long-term Interest Rates % Euro Long-term Interest Rates % U.S. Current Account $ Bil Euro Current Account $ Bil U.S. Financial Account $ Bil Euro Financial Account $ Bil U.S. GDP $Tril Euro GDP Tril Euro Relative to U.S.$ Daily Avg Euro Effective Exchange Rate 2000= Source: OECD and IMF. A