Walt Disney Case Study

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The WD Company’s ¥ Financing

question 1.
The decision of whether or not to hedge the exchange rate exposure ultimately depends on Walt Disney (WD) manager’s attitude about risk and philosophy concerning the proper role of the treasury functions in the overall management of the firm. Arguments can be made for both sides of this issue.

On one hand, if WD is a relatively conservative company in the entertainment and recreation businesses and assuming it could buy insurance against exchange rate fluctuations at a fair price, then it should hedge. Long term planning might also be easier if the currency risk is hedged.

On the other hand, it might be argued that WD has a different perspective on exchange rate movements. While WD might not have been able to predict exchange rate movements systematically, there seemed to be evidence in 1985 that the ¥ was extremely undervalued. Using the data in Exhibit 4 of the case, it would appear that the ¥ has depreciated substantially in real terms, the real rate having gone from ¥225.7/$ in 1980 to ¥284.69/$ in second quarter in 1985 (the real exchange rate, st, is calculated by multiplying the nominal spot exchange rate St, by the ratio of the U.S. CPI index to the Japanese CPI index at time t; thus the real exchange rate in second quarter 1985 was 284.69=250.80 (130.2/114.7). This would suggest that a turn around in the value of ¥ was inevitable sooner or later according to the long term convergence of the exchange rate.

Due to high volatility in the foreign exchange market, recent depreciation of ¥ against the dollar and sensitivity of cash flows to changes in exchange rates, we believe foreign exchange exposure should be hedged.

Question 2.
The main issue that should be looked at is how far into the future should WD hedge. Liquid markets for options and futures contracts existed only for maturities of 2 years or less. Even if the problem with forward contracts is similar, WD obtained an indication of long-dated currency forward rates from its banks.

Assuming that hedging is desirable, WD can choose among the following alternatives:

(a) Foreign Exchange Forward Contracts - WD can sell a currency forward contract and will be entitled to sell a specified amount in a specified currency (in this case, ¥) for a stated price on a specified date. To hedge the home currency value of future receivables in a foreign currency, the firm may sell a currency forward contract for the currency it will be receiving. Therefore, the firm knows how much of its home currency it will receive after converting the foreign currency receivables into its home currency. By locking in the exchange rate at which it will be able to exchange the foreign currency for its home currency, the firm insulates the value of its future receivables from fluctuations in the foreign currency’s spot rate over time. Forward contracts are negotiated between a company and a commercial bank and specify the currency, the exchange rate and the date of the forward transaction. Problems: available at low cost only until 2 year maturity (see Exhibit 5) due to the high bid-ask spread; even if a quote is available, the dealers could not be willing to transact in any substantial size.

(b) Currency Futures - Like forward contracts, futures contracts can be used to lock in the future exchange rate at which a company can buy or sell a currency. A forward contract hedge is very similar to a futures contract hedge, except that forward contracts are commonly used for large transactions and can be executed for any quantity for any maturity date, thus they are not as liquid as the futures, which are standardized contracts representing a fixed number of units for each currency.

(c) Currency Options - A firm must assess whether the advantages of a currency option hedge are worth the price – premium – paid for it. WD can hedge its ¥ receivables with currency put options. A currency put option provides the right to sell a...
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