After learn the key concepts that govern the firm?s treasury function, both from a technology or systems perspective, as well as from a theoretical perspective.We have examined in detail how the treasury function supports the firm as a whole, and the significant role that ethical behavior plays in proper treasury management.

This assignment, you will address an important treasury function, Risk Management.You should analyze the information in the case and address each of the 10 questions at the end of the case. Be sure that all recommendations are fully supported by data provided as well as best practices. Please find the case in the attachment.

32 Hedging with Derivatives When in Doubt, Hedge! It was a hot, humid afternoon in April and Matt could feel the pressure mounting. The memo on his desk read, "Please see me immediately!" Matt knew that, sooner or later, his boss, Lance Foster, was going to ask him to implement some quick remedies to improve the profit situation. The quarterly financial statements had just been published and for the fourth quarter in a row, The Dependable Pipe Company had reported a sharp drop in earnings per share despite a consistent increase in revenues. Needless to say, the shareholders were irate and the public relations department had been inundated with calls from concerned shareholders wondering what was going on. In fact, at the annual general meeting held last quarter, the shrinking profits of the firm were the main topic of discussion. It led to the early retirement of the Chief Financial Officer, Ed Hartley. The Dependable Pipe Company was headquartered in Delaware and had established manufacturing facilities in Illinois, California, Ohio, and Pennsylvania. It specialized in the manufacture of high-grade copper piping c primaril: accountt sales to Table 1' ~tabl.e pi surgmg copper \\'i price tha stiff corr unable tc worse, tb resulting dollars. 1 its currer overseas terms inc. p Hartley, I market. 1 exchange appointed derivati\\"e western w Exchange offer that pressure "' Case 32 s lge! n: could feel the Ge see me Lance Foster, was o improve the profit )eeJ1 published and Company had :.ansistent increase in and the public 1-m concerned ~ me annual general fum were the main : Chief Financial ;s. u.anered in Delaware ois, California, Ohio, of high-grade copper When in Doubt, Hedge! 169 piping of various thickness and circular dimensions. The pipes were used primarily in commercial and residential applications. 70% of its sales were accounted for by exports to the United Kingdom while the rest came f!om sales to wholesalers in the USA. Over the past year, copper prices had fluctuated significantly (see Table 1). The firm had been unable to purchase high-grade copper at ~ stable prices, leading to a significant erosion of corporate profits despite "surging sales. The orders had been booked at a time when the price of copper was at its lowest level in twelve months ($0.62/lb.). That was the price that had been figured into the cost structure. Unfortunately, due to the stiff competition that characterized the piping industry, Dependable was unable to shift the price increases on to the wholesalers. To make matters worse, the US$ had strengthened significantly over the prior twelve months resulting in further loss of profits upon conversion of British pounds into dollars. The dollar had gone from $1.55 per pound, twelve months ago, to its current level of $1.43 per pound. Due to the fierce competition. in the overseas market, British wholesalers were able to negotiate very favorable terms including ninety days credit and payment in British pounds. Part of the problem at Dependable was that the previous CPO, Ed Hartley, had not been very familiar with the mechanics of the derivatives market. He had therefore not hedged the company's commodity and exchange rate exposures at all. Upon Ed's retirement, Lance Foster, was appointed as the CFO. Lance's first move was to recruit Matt Keenan, a derivatives expert. Matt had earned an MBA in Finance at a major ~d western university and had worked for five years at the Chicago Mercantile Exchange, prior to joining Dependable. The company had made him an offer that was too good to resist and Matt knew that sooner or later the pressure would be on to prove his worth. 170 Case 32 When in Doubt, Hedge! Table 1 smile on hi we meetri~ Historical Spot Prices of High-Grade Copper Month end May June July August September October November December January February March April Price (cents/lb.) 2004 2004 2004 2004 2004 2004 2004 2004 2005 2005 2005 2005 62.00 64.75 66.25 65.70 67.30 64.45 61.80 70.40 71.50 73.35 74.50 76.10 In preparation for the meeting with Lance, Matt gathered information from the purchasing, sales, payables, and receivables departments. The sales department had booked orders for $50 million worth of pipes, 70% of which was from British clients. Matt estimated that the company would need about 40 million pounds worth of high-grade copper by the end of three months to manufacture the pipes. Copper was being quoted at $0.72 per pound in the spot market and the British pound was quoted at $1.42 per pound. There was a likelihood that copper prices could go down and the dollar could weaken against the British pound, but the reverse could also happen. Matt knew all too well that the market could go either way and remembered vividly what his prior boss used to often say, "When in doubt, hedge!" He feared that if copper prices were to appreciate along with the dollar, corporate profits would be significantly affected and he would be out looking for a job. He liked this company and the lavish compensation package he had been offered was definitely worth keeping. "I had better come up with some effective hedging combinations," thought Matt. "This is no time to take a wait and see approach." Matt tapped on his laptop and checked the Internet for the latest quotes on futures contracts trading on the British pound and on high-grade copper (see Tables 2 -5). After jotting down some numbers and making some quick calculations, Matt picked up the phone. "Lance," he said with a - MTH/ STRIKE OPEl. JUNOS 1.432.! SEPOS 1.42::..: TOTAL ----------- - TraCi Price Tract Initial Maim Case32 When in Doubt, Hedge! 171 smile on his face, "About that meeting you wanted to have with me ... Can we meet right away?" ~opper Table 2 nh.) British Pound Futures - Contract Specifications Trading unit: Price Quotation: Trading symbol: Initial margin: Maintenance margin: 62500 British Pounds US$ per Pound BP $1 080 per contract $ 800 per contract Table 3 British Pound Futures Settlement prices as of April 2005 :ce. Matt gathered :. and receivables e:s for $50 million . ~tatt estimated that "'orth of high-grade e. pipes. Copper was ~the British pound IC that copper prices :c British pound, but hzt the market could -: boss used to often ~per prices were to mid be significantly ~ this company and 1:1s defmitely worth lging combinations," proach." ::ernet for the latest d and on high-grade I.unbers and making wee," he said with a MTH/ ---- DAILY -- STRIKE OPEN HIGH EST LOW LAST --- PRIOR DAY - SEn CHGE VOL. SEn JUN05 1.4324 1.4332 1.4296 1.4312 1.4314 -20 1792 1.4334 SEP05 1.4230 1.4256 1.4228 1.4250 1.4234 -20 TOTAL 1 1.4254 1793 OPEN VOL. INT. 7901 35237 31 880 7932 36117 Table 4 Copper Futures- Contract Specifications Trading unit: Price Quotation: Trading symbol: Initial margin: Maintenance margin: 25000 lbs. cents per lb. For example, 75.80 cents per lb. HG $1350 per contract $1000 per contract Case 32 172 When in Doubt, Hedge! Table 5 5. \\X..n:agail Copper Futures Settlement Prices as of April2005 CONTRACT HG 04 05 EXPIRATION DATE 4/26/2005 TODAY'S PREVIOUS SETTLE SETTLE VOLUME 64 71.5 72.1 HG 0505 5/29/2005 71 .7 72.3 HG 06 05 6/26/2005 72.05 HG 07 05 7/29/2005 HG 08 05 6. 'A-na unpa DAILY HIGH 71.6 DAILY LOW 71.6 7,039 72.4 71.2 72.65 58 72.15 71.95 72.4 73 1,942 73 71 .9 73.3 10 73.1 72.5 8/28/2005 72.7 HG 09 05 9/26/2005 72.95 73.5 125 73.45 72.75 HG 10 05 10/29/2005 73.2 73.7 3 73.25 73.25 HG 11 05 11/25/2005 73.45 73.95 2 0 0 HG 12 05 12/27/2005 73.7 74.2 234 74.25 73.3 Questions: 1. What is meant by the term "transactions exposure"? What kind of transactions exposure is The Dependable Pipe Co. faced with? 2. How much variability has there been in the spot price of highgrade copper over the past twelve months? Is it large enough to warrant the need for hedging? Please explain. 3. 4. What kind of hedging strategy should Matt recommend for minimizing Dependable's exposure to volatility in copper prices? Design a suitable hedge and show what would be the result if copper prices went to 77.5 cents per lb. at the end of three months when the company would be ordering the high-grade copper. How should Matt respond if Lance argues that there is a good chance that copper prices could be coming down? 7. Usin! suiraf flucu Pour:.; when excha 8. Lance use fo 9. Durin) forced credit have J: of thei and m: firm ct plus 1 availale and asi swap ~ respon( 10. Beside~ recomn interesr Case 32 When in Doubt, Hedge! 173 5. Why is Matt concerned about the dollar strengthening in value against the British pound? 6. What hedging strategies can Matt recommend to minimize the impact of exchange rate volatility? DAILY LOW 71 .6 71.2 71.95 71.9 72.5 72.75 73.25 7. Using the data given for British Pound futures contracts design a suitable hedge that would minimize Dependable's exposure to fluctuations in the exchange rate between the US$ and the British Pound. Explain the results of the hedge if by September 2005, when payment is received from the British wholesalers, the exchange rate goes to $1.35 per British Pound. 8. Lance questions Matt, "What about forward contracts? Why not use forward contracts instead?" How should Matt respond? 0 73.3 ' Wbat kind of ced with? price of high.rge enough to :commend for copper prices? e the result if ,f three months ~ copper. :tere is a good 9. During their meeting, Lance told Matt that the firm had been forced to use floating-rate loans for expansion due to their low credit rating. Although long-term rates were higher, the firm would have preferred to match the maturity of the debt with the duration of their financing need. Besides, short-term rates had been rising and were expected to continue going up due to rising inflation. The firm currently had borrowed $2 million at a floating rate of prime plus 1% (currently 6.5%). Longer-term, fixed rate debt was available at 9% per year. Lance had heard about interest rate swaps and asked Matt to explain to him how Dependable could use a swap to minimize their interest rate risk. How should Matt respond? 10. Besides an interest rate swap, what other strategies could Matt recommend to Lance to help minimize the company's exposure to interest rate risk