Great Eastern Toys is a company in Hong Kong that exports a huge percent of its total sales to the North American and European markets and hence is exposed to currency risk. Previously, the company was occupied with expanding their business and the company's management had never given much attention to currency risk until their recent meeting with their banker. The banker pointed out that the depreciation of the European currencies during the previous two years had resulted in a substantial loss of income. The company's management was indeed convinced that they should begin to devote more time and manage their currency position. In this report, we are going to explore the different options for Great Eastern Toys to hedge its currency exposure and recommend the best hedging strategy for them.
Currencies to Hedge
Great Eastern Toys with annual sales of over HK$245 millions (US$31 million) exported about half of its products to North American markets, close to 50% to Europe, and less than 5% in the local market. This resulted in incoming cash flows denominated in Deutsche Mark and U.S. dollar. The firm finances its operations mainly with the local currency, Hong Kong dollars, but also with Yen loans. As for loans, the firm had borrowed about HK$ 24.45 million and ￥ 120 million (HK$ 6.64 million).
As half of the sales revenue is denominated in U.S. dollars, it is necessary to examine whether or not to hedge the currency exposure from the U.S. dollar. For more than ten years, the Hong Kong dollar has been firmly pegged to the U.S. dollar. Thus the currency risk on Great Eastern Toys' American sales was seen as practically insignificant. Even if the peg were to be removed, the Hong Kong dollar is expected to depreciate against the U.S. dollar, since the Hong Kong dollar appears to be substantially overvalued, as the annual inflation in Hong Kong is running at double the rate than in the U.S. Accordingly, we believe that Great Eastern Toys can leave open the exposure from the export sales in U.S. dollars.
A large portion of the sales revenue is received in Deutsche Marks, DEM, by Great Eastern Toys. During the recent meeting with the banker, the banker directly pointed out that the depreciation of the European currencies in the last two years had resulted in a huge loss. At this point, it seems quite vital to consider hedging strategies against the depreciation of DEM. Most European currencies had been depreciating against the dollar during the past three years, with no exception for DEM. It might be believed that this is about time the trend will be reversed. If the Euro becomes a reserve currency after the Europeans adopt the Euro as their common currency, a strong worldwide demand will form and indeed its value will appreciate. However, at the moment, there seems to be many other factors that will limit the potential rise in the value of the European currencies. Accordingly, we have decided that Great Eastern Toys should hedge against the depreciation of the DEM.
Lastly, since the firm currently has an outstanding debt of ￥ 120 million, equivalent to HK$ 6.64 million, Yen needs to be considered as well whether or not to hedge against its currency exposure. For the past three years, the Yen has been steadily declining against the HK$ from 11￥/HK$ to currently about 18￥/HK$. To determine whether the Yen is expected to depreciate or appreciate, we have used the following expression of the international fisher parity:
[E(S￥/HK$) – S￥/HK$]/S￥/HK$ = (rN￥ - rNHK$)/(1+rNHK$)
By plugging in the relevant values into the above formula, we can compute the expected exchange rate between Yen and HK$:
[E(S￥/HK$) – 18.0]/18.0 = (5.5% - 0.4%)/(1+0.4%)
E(S￥/HK$) = 18.9 ￥/HK$
According to international fisher parity, therefore, the Yen is expected to depreciate. Based on the fact that the Yen is expected to depreciate in value as well as the fact that the...