Problem 8.3 Warner Indonesia

Warner, the U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterol- reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in this case, a cash settleemnt of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared unattractive, Warner had to contact several major banks before even finding a forward quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging recommendation.

Assumptions Values At Spot Receivable due in 3 months, in Indonesian rupiah (Rp) Rp1,650,000,000 $174,603.17 Spot rate (Rp/$) 9,450 Expected spot rate in 90 days (Rp/$) 9,400 3-month forward rate (Rp/$) 9,950 Minimum dollar amount acceptable at settlement $168,000.00

Risk Alternatives Values Assessment

1. Remain Uncovered.

Settle A/R in 90 days at current spot rate.

If spot rate in 90 days is same as current $174,603.17 Risky (Rp750,000,000 / Rp8,800/$)

If spot rate in 90 days is Rp9,400/$ $175,531.91 Risky (Rp750,000,000 / Rp9,400/$)

If spot rate in 90 days is Rp9,800/$ $165,829.15 Risky (Rp750,000,000 / Rp9,800/$)

2. Sell Indonesian rupiah forward.

A/R sold forward 90 days $165,829.15 Certain

"Cost of cover" is the forward discount on Rp -20.1%

Analysis

The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level.

Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets.

In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using forward cover. Problem 8.18 Tek -- Italian account receivable

Tek wishes to hedge a €4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment is due in 3 months. Tek’s Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank has offered Tek the following quotes:

Assumptions Values Account receivable due in 3 months, in euros (€) € 4,000,000.00 Spot rate ($/€) 1.2000 3-month forward rate ($/€) 1.2180 3-month euro interest rate 4.200% 3-month put option on euros: Strike rate ($/€) 1.2000 Premium, percent per year 3.400% Tek's weighted average cost of capital 9.800%

a) b) What are the costs and risk of each alternative? Value Certainty?

1. Do nothing and exchange euros for dollars at end of 3 months Amount of euro receivable € 4,000,000.00 If spot rate in 3 months is the same as the forward rate 1.2180 Very uncertain; US dollar proceeds of receivable would be $4,872,000.00 Risky

Amount of euro receivable € 4,000,000.00 If spot rate in 3 months is the same as the current spot rate 1.2000 Very uncertain; US dollar proceeds of receivable would be $4,800,000.00 Risky

2. Sell euro receivable forward at the 3-month forward rate Amount of euro receivable € 4,000,000.00 forward rate 1.2180 Certain; US dollar proceeds of receivable would be $4,872,000.00 Locked-in

3. Buy a put option on euros Amount of euro receivable € 4,000,000.00 Current spot rate ($/euro) 1.2000 Premium on put option, % 3.400% Cost of put option (amount x spot rate x percent premium) $163,200.00

If the spot rate at end of 3-months is less than strike rate Minimum is the option is exercised yielding gross dollars of $4,800,000.00 guaranteed; Less cost of option (premium) plus US$ interest on premium (167,198.40) could be Net proceeds of A/R if option is exercised (this is Minimum) $4,632,801.60 greater.

Summary of Alternatives Value Certainty? Do Nothing $4,800,000.00 Risky Sell A/R forward $4,872,000.00 Certain Buy Put Option $4,632,801.60 Minimum c) If Tek wishes to play it safe, it should lock in the forward rate. d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3-month period, past $1.20/€, then Tek might consider purchasing the put option on euros.