Forward Market Hedge For Merton example essay topic

Merton Electronics Corporation was founded in 1950 as a distributor of electrical and electronics products for consumer and institutional products. It imports a wide range of electronic goods from personal computers to cassettes from Japan and Taiwan, which are then distributed to retail firms and dealers. The company is facing heavy competition with slowing sales and increasingly smaller margins. One of the major issues facing the firm is the risk associated with the import of the foreign goods from Japan.

In order to determine the proper hedge to be used in this case the risk must first be identified. Due to the international nature of Merton Electronics' business, the company could face a very high degree of currency risk. Currency risk is simply the degree to which the business is affected both positively and negatively by changes in exchange rates. It can refer to potential losses in investments, business transactions, and operating expenses due to fluctuations in exchange rates. In this case, Merton is suffering from currency risk on payable accounts used to finance imports from Japanese suppliers. The exchange rate has been moving against Merton opening themselves up to a loss of over $900,000 in payments to the Japanese suppliers.

Currency risk exposure can be further defined as translation exposure, transactional exposure, and operating exposure. Translation exposure is pure accounting exposure. It applies to changes in accounts on the balance sheet and income statement due to exchange rate changes. They are simply paper gains and losses governed by the Financial Accounting Standards Board (FASB). Transaction exposure or cash flow exposure can be both an accounting and operating exposure. It stems from the possibility of incurring exchange rate gains or losses on transactions already entered into and denominated in foreign currency.

Transaction exposure is the actual or real gain or loss in the exchange of one currency for another. Operating exposure or competitive exposure is applies to changes in operating cash flows that will occur at some point in the future. The exchange rate fluctuations combined with price level changes can increase the riskiness of the firms future revenues and costs. These exchange rate fluctuations are also real in regard to gains and losses but they are long term in nature. In this case, Merton Electronics is facing transaction exposure in regard to the payable to the Japanese firm for the goods that were ordered in January. Any change in the $/yen exchange rate will affect the amount of the payable.

Merton Electronics' can choose from four possible hedging methods or they can choose to do nothing. First, it could continue to use the forward market hedge. A forward contract is an agreement between two counter parties to exchange one asset for another at a specified time in the future. Hence, some quantity of the foreign currency Yen (yen) will be exchanged at a later date for a $ denominated payment. The forward market hedge for Merton would be based on a 90-day forward rate and would be termed in the yen. The goods were purchased in January and must be paid for in April.

The forward market hedge would protect Merton against increases in the value of the yen during the 90-day period between the order and the payment. The calculations can be found in Appendix 1. The advantages of the forward contract are the value of the payable becomes fixed at the time of the order and the initial outlay is minimal to zero. No assets or goods change hands until a specified time in the future.

The forward contracts do have some inherent disadvantages. There is no central market for forward contracts thus the forward contracts have lower liquidity, counter party risk and they are irrevocable. With the forward contract, favorable movements in the exchange rates cannot be recognized. The contract is binding and the terms are likely not able to be changed after the contract has been signed. The second possible hedge is the money market hedge. The money market hedge involves the simultaneous borrowing and lending of the two currencies in question.

Merton Electronics will need to borrow dollars today and convert those dollars to yen at the current spot rate and invest in a yen denominated money market. The proceeds will be used to pay the yen 300 M payable in 90 days. The calculations can be found in Appendix 2. In order for this hedge to work effectively, interest rate parity must hold. The outcome of a money market hedge is determined by the interest rate differentials. The advantage of the money market hedge is the same as the forward contract the value of the payable becomes fixed.

There are also disadvantages using the money market hedge. The money market hedge can be fairly complex and the may be both transaction and tax costs. Any favorable exchange rate movements will not be recognized if Merton uses the money market hedge. The firm could also become overly leveraged which could cause an imbalance in their optimal capital structure. If interest rate parity holds, and transaction costs are ignored, the forward hedge and the money market hedge will yield identical results.

The third possible hedge is a currency futures hedge, which uses a futures contract to hedge the changes in exchange rates. The futures contracts are highly standardized in terms of the fixed quantities, a specified delivery date, and a fixed price. Merton Electronics would need to purchase 24 contracts based on the standard size of 12,500,000 yen per contract to cover the 300,000,000 yen payable. If the yen depreciates against the US$ fewer dollars will be needed to settle the contracts with the Japanese suppliers but Merton will need to use that savings to settle the futures contracts used in the hedge.

The calculations can be found in Appendix 3. An advantage of the currency futures hedge is they trade on an organized exchange and delivery is guaranteed via the clearinghouse. The payable also becomes fixed using this hedge. If the futures contract is no longer desirable an offsetting position or a reverse trade can be undertaken in the futures market, so the buyer would not be obligated to physically delivery the particular currency. The main disadvantage is the need to maintain a margin account because the contracts are marked to market on a daily basis.

In the event that the exchange rates move unfavorably, additional marginal deposits may be necessary. In the event that the exchange rates move favorably, gains could not be recognized using the currency future contract. The fourth possible hedge is a currency option hedge, which uses an option contract to hedge the changes in exchange rates. The currency option is similar to the currency future in terms of the specified price and contract size.

However, currency options are just that options they are not obligations to fulfill contracts. The owner of a call or put option has the right to purchase or sell the underlying currency but they are not obligated to do so. For Merton Electronics to hedge using currency options 48 options would need to purchased based on the standard size of 6,250,000 yen to cover the 300,000,000 yen payable. After the 90-day period when Merton must pay the supplier if the spot rate is greater than the strike price the option would be exercised.

If the opposite where true and the spot rate is less than the strike price the option would expire worthless. The calculations can be found in Appendix 4. The primary advantage of the currency options are the potential gain that can be realized from favorable movements in exchange rates. Another advantage in using the option contracts is the inherent flexibility. The options contracts also trade on organized exchanges and the deliveries are guaranteed via the clearinghouse. The major disadvantage in using the currency options is the premiums paid to acquire the options.

Merton Electronics could also choose not to hedge the potential currency risk at all. There would be advantages to the company if it decided not the hedge. There would be no costs associated with a hedging activity. The choice could also allow the financial manager to focus on running the business instead of monitoring hedging activities. If the hedging strategies are not properly used and monitored, they can be detrimental to the business. The disadvantage is the presence of currency risk and the uncertainty of cash flows due to exchange rate fluctuations.

Merton Electronics should develop a hedging policy that can be referenced when other currency risk situations arise. However, each hedging technique should be evaluated on a case-by-case basis. If Merton uses the forward hedge, the money market hedge, or the currency future the cash flows can be determined with certainty. The options contract limits the loss to the premium paid for the option but provides for unlimited gain.

Given the inherent flexibility of the currency option, in this case Merton Electronics should buy the call options at the $. 7968 strike price. This option should be chosen over the $. 7852 strike price because it is unrealistic to assume the exchange rate will not move over the next 90 days. If that were the case, Merton should remain un hedged. The call option with the $.

7968 strike price is more realistic because it takes into account the 90-day forward rate. Should the exchange rate move lower than the current spot rate, Merton would simply allow the option to expire worthless and the most they would loose would be the $44,940 premium paid. Given the volatility of the foreign currency markets, the flexibility of the currency option would be a better choice for Merton especially considering their past experiences with the forward contracts. Merton should develop a hedging strategy that will best protect themselves against losing revenue due to exchange rate moves.

The options hedge provides this flexibility. The most appropriate time for Merton to exercise their hedging strategy is at the time that the order has been placed. Merton will then be able to look at all of the options discussed above, and determine what the current exchange rate trend is doing. Based on the Exhibits within the case, the trends have shown that the exchange rate is more favorable. Not all of the identified exposures should be hedged. If international parity holds, then over the long term the exchange rate fluctuations should be a zero sum game and nothing would be gained by hedging.