Exchange Rate Market Case Study

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Exchange Rate Market

1. If you were the Vice President for Treasury at ZAPA, What Benchmarks would you Use to Measure Stephanie’s Hedging Effectiveness?

To measure Stephanie’s hedging effectiveness, I would prefer to use a cost as a benchmark. My decision is based on several issues:

1. Taking into account the policy of ZAPA and after observation of it, it becomes clear that the company considers Treasury, which the main function is to manage the exposure, as a cost center, (but not as profit).

2. The first idea is represented in a phrase which was used in the case study and presented the fact that the “expenses of running the cost center” are expected to below.

3. The theory, which is used by ZAPA’s policy, pursues the goal of maximizing the expected value and minimizing the variance. What is the “variance”? It assumes risks.

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Based on the above, what results do we get? Measuring the risk, which can be the implication of the company’s philosophy of measuring the money, assumes that money could be lost. The same thing happens when we measure Stephanie’s hedging effectiveness. That becomes the main reason why the cost is the best benchmark for the user in this case, in my opinion.

2. How would this Alter Stephanie’s Hedging?

After measuring Stephanie’s hedging effectiveness, she will be able to choose cheaper (if it is possible to say in this way) and less speculative, than other options, forward hedge. However, we still should keep in mind the policy of the company, which is based on the previous experience of losses which were caused by forwarding contracts. That is the reason why foreign exchange options were used “whenever possible”.

Currently, for ZAPA’s exposure there are several hedge alternatives:

1. Remain uncovered – this is the maximum risk approach with the spot exchange rate: DM 1,4649/$.

2. Forward cover – selling DM forward, at 120-days forward rate. In this case, totals DM 1,4957/$ with a rate of annual discount at 6,2%.

3. The option of foreign currency conversion, in which case she should utilize – buy put-scenario in DM, and the strike price: DM 1,5152/$ (at $0,66/DM). Premium at 1.40 % per DM. The total outlay for protection: $0.014 * 7.6 million.

To be able to participate in currency gains, Stephanie decided to buy the put-option. According to data, sale of a put option and forward hedge result in a higher outcome, as compared to option hedge (the worst-case scenario), as well as at the present spot rate. However, forward hedge option does not favor benefits from falling US dollar.

3. In light of Current Events in Europe, Hypothetically, if the Exchange Rate Market (ERM) is Eradicated, What Implications Would that Have on the DM and ZAPA Company?

It will influence not only DM or ZAPA Company but also the currencies in different countries. The question, which should be answered, is if there will be fixed exchange rates. Surely, if they will exist, there will be no uncertainties towards the currencies of different countries. Moreover, people would not be afraid that they are going to lose changing their currency into another currency, one and vice versa. Other several benefits of fixed rates are that they will reduce risks existing in international trade; this will make economic management disciplined as well as eliminate speculations which destabilize economies.

Unfortunately, such an opportunity is not clear. More dominant countries still will try to influence the economies of less developed countries as their currency is more valuable.

If talking about the DM and ZAPA Company, their future depends on the opportunity of making the exchange rates fixed. Otherwise, if DM is not competitive towards the US dollar, it will lead it under pressure of the US dollar and, as a result, make it devalued. The speculators know about such opportunity and will make further pressure on the currency, as well as the economy and government (consequently).

4. What Hedging Position should Stephanie Invest in to Protect against Sudden Changes in the Foreign Exchange Markets?

The volatility of the US dollar is high: from DM 1,39/$ on September 1, 1992, to DM 1,51/$ on September 16, 1992). While taking this and 3 months till repatriation, the only possible solution for Stephanie which I can see is to sell put and enter into forwarding agreement.

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