Baker Adhesive Case

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  • Topic: Currency, United States dollar, Foreign exchange market
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  • Published : March 27, 2012
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John Kroeger
FINA 470
Baker Adhesive Case
March 22, 2012

1. How profitable is the original sale to Novo once the exchange-rate changes are acknowledged? How has the exchange-rate risk, which affected the value of the order, been managed?

In the original order, Nova was billed BRL 104,338.30 for their purchase. After the exchange of currency from BRL to U.S. dollars, Baker was estimated to receive $48,371.24 (104,338.30 * .4636). This means that Baker brought in $55,967.06 less from their deal with Nova than was expected. Since the exchange-rate risk was not managed, Baker brought in significantly less than was estimated from their deal with Nova and after subtracting their total cost from what they brought in, Baker only made a $3,871.20 profit on the deal when they expected to make a $59,383.30 profit. To manage the exchange-rate risk of their deal with Nova, Baker could have hedged in the forward market or hedge in the money market. In order to hedge in the forward market, Baker would have to strike a deal with the bank where the bank would provide Baker with a guaranteed exchange rate for the future exchange of currencies (forward rate). These contracts specified a date, an amount to be exchanged, and a rate. Any bank fee would be built into the rate. By securing a forward rate for the date of a foreign-currency-denominated cash flow, Baker could eliminate any risk due to currency fluctuation. For Baker, this meant that the anticipated future inflow of real from the sale to Nova could be converted at a rate that would be known today. Hedging in the money markets on the other hand, would allow Baker to make any currency exchanges at the known current spot rate. To do this, Baker would need to convert future expected cash flows into current cash flows. This was done on the money market by borrowing “today” in a foreign currency against an expected future inflow or making a deposit “today” in a foreign account so as to be able to meet a future outflow. The amount to be borrowed or deposited would depend on the interest rates in the foreign currency because Baker would not wish to transfer more or less than needed.

2. Assuming Baker agrees to the new Novo sale, determine the present value of the expected future cash inflow assuming: (1) there is no hedge, (2) the company hedges using a forward contract, and (3) the company hedges using the money market.

No hedge:

Present Value:
86.23 * 1815= BRL 156,362.25
BRL 156,362.25 * .4368= $68,299.03

Future Value:
BRL 156,362.25 * .4234= $66,203.78

Hedge using forward contract:

Present Value:
66,094.32 / (1 + .0215)= $64,703.20

Future Value:
BRL 156,362.25 * .4227= $66,094.32

Hedge using money market:

Present Value:
BRL 156,362.25 / (1 + .065)= BRL 146,819.01

BRL 146,819.01 * .4368)= $64,130.54

3. Are the money markets and forward markets in parity?

The above data shows the calculations for the present value of the expected future cash inflow assuming there is no hedge, the company hedges using a forward contract, and the company hedges using the money market. These calculations are done using the current price per gallon of adhesives at 86.23 in Brazilian Real. As you will see below we take into account the change in material cost and find the new price per gallon of the adhesive. This turns out to be 88.39 and we go on to calculate the new present value of the expected future cash inflow assuming there is no hedge, the company hedges using a forward contract, and the company hedges using the money market. The data below shows that the money markets and forward markets are not in parity. We come to this conclusion by looking at the different interest rates. The difference between the discount rates of 6.5% used to arrive at the PV of the money market loan and 5.08% used to arrive at the PV of the anticipated future inflow of BRL from the sale to Novo converted at a forward rate of 0.4227 are the reason why the money...
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