Case Study Daewoos Unorthodox Funding Strategy

This case study accompanies Chapter 7 of International Corporate Finance. Daewoo Corporation, headquartered in Seoul, South Korea, was established in 1967 by an entrepreneur named Woo Choog Kim and soon became one of the largest corporations in all of South Korea. Its 1987 unconsolidated annual sales amounted to some US$5.6 billion, which made Daewoo the number four chaebol in South Korea.

Daewoo was mainly involved in three lines of activities: international trading, domes- tic and overseas construction, and textile goods manufacturing, with 31 domestic and

16 foreign subsidiaries. It was the third-largest exporter in terms of volume among

South Koreas seven general trading companies, was the number two general contrac- tor, and was rapidly diversifying into industrial and consumer durables. As for its

major rivals, the only check on Daewoos explosive growth was its access to capital.

As the fi nancing arm of Daewoos International Trading division, the main re- sponsibilities of the Foreign Exchange and Trade Finance department were trade

fi nancing, treasury, and management of foreign exchange risk. At a time when the Bank of Korea was attempting to cool off the economy through a tight monetary policy, the department was under mandate to raise as much money as possible to help solve Daewoos perennial capital shortage. Mr. Y. D. Ahn had become the general manager of the Foreign Exchange and Trade Finance department in 1985 after receiving his MBA from the Wharton School on a company scholarship. Charged with the task of raising capital for Daewoo, Mr. Ahn, with the help of three part-time dealers, soon turned to creative fi nancing techniques. Indeed, an exciting opportunity presented itself at the end of 1987 when South Koreas Ministry of Finance allowed the use of currency options by listing

them as authorized fi nancial tools in the Foreign Exchange Control Regulations. Af- ter a month of research and detailed discussions with a couple of banks, Mr. Ahn and

his team concluded that writing deep-in-the-money currency options could become a very effective method of raising funds.

WRITING DEEP-IN-THE-MONEY OPTIONS In early 1988, Mr. Ahn approached four American banks, Supreme Federal County Bank (SFCB), Trace Queens Bank (TQB), Financiers Guild Bank (FGB), and Fabricators Bremen Bank (FBB), with his new scheme. By the end of January, SFCB,

FGB, and FBB had presented Mr. Ahn with their respective terms and conditions for Daewoo to write -put/$-call options at a strike price of 100/US$1. SFCB was the fi rst to give a letter of intent, and its representatives informed Mr. Ahn that no legal diffi culties would arise from trading deep-in-the-money options as long as their options were backed by real demandthat is, legitimate underlying transactions. Meanwhile, as options were quickly discovered by the fi nancial community, Mr. Ahn hurriedly approached Mr. I. T. Shan, president of Daewoo Corporation, on

February 3, 1988. Although it was relatively easy to explain options to his immedi- ate superior, Managing Director (M/D) T. M. Kang, who was a former central bank

offi cial, more detailed explanations were needed for the president and for Mr. M. L. Park, the vice president (V/P) and treasurer. In these few briefi ngs outlining the overall structure of the deals along with the associated risks, Mr. Ahn had to evaluate the advantages of the new product on the basis of a conservative 5 percent annual won-appreciation scenario and an 11.5 percent internal cost of capital. At that time, the rate of won appreciation was expected to be more than 10 percent per annum, and Daewoos internal rate of interest to be applied in managerial accounting was 14 percent per annum. On February 12, Mr. Ahn obtained fi nal approval from the president of Daewoo Corporation. Permission to write the options, however, was contingent upon the total position being less than US$200 million and Mr. Ahn

maintaining a very conservative approach (i.e., minimizing Daewoos undue expo- sure to foreign exchange risk).

As shown in Case Exhibit 7.1, Daewoo wrote four option contracts, two with FGB and one each with SFCB and FBB. The principal amount of each contract was 5 billion, or US$50 million, and the strike price was 100/US$. In fact, two deals had already been completed before fi nal approval was received because Mr. Ahn and M/D Kang had decided to seize the opportunity before the market changed signifi - cantly. From the four contracts, Daewoo received a total sum of US$35.8 million

in premiums, or 27.7 billion won, on 20 billion to be received in one year in ex- change for US$200 million, which indicated that the negotiated premiums com- pared less than favorably with those quoted on the Philadelphia Exchange Market

(Case Exhibit 7.2). However, Mr. Ahn was in no position to reject a deal simply be- cause of the high price; the option-loan market had already turned out to be a buy- ers market, and Mr. Ahn was especially encouraged by the growing expectations of

a substantial won appreciation against the dollar, which according to many forecasts would reach 680 won per dollar by years end. TO HEDGE OR NOT TO HEDGE? Mr. Ahn was also the convener of Daewoos Foreign Exchange Rate Committee. With M/D Kang as chairman, the committee met on the second business day of each month and determined the monthly won/dollar exchange rates for the coming 12 months to be used in various business plans of the corporation. At the February

meeting, the committee revised the year-end rate from 720 won to 650 won per dollar, an appreciation of nearly 22 percent. Since the option loans were denominated

in U.S. dollars, Daewoo would benefit from savings of roughly 18 percent if the predicted won appreciation occurred.

CASE EXHIBIT 7.1 Writing Options Option style: European; yen-put/dollar-call Contract amount: US$50 million (5 billion) each Strike price: 100/US$ (In thousand US$, million won)

Bank	Contact	expiry	settlement	date	Amount (USS)	Amount(Won)	B/E*(
SFCB	08-Feb-88	08-Feb-89	10-Feb-89	10-Feb-88	8,850	6,888	126.22
FGB	12Feb-88	10-Feb-89	14-Feb-89	16-Feb-88	9,000	6,960	126.78
FGB	17-Feb-88	15-Feb-89	17-Feb-89	19-Feb-88	9,175	7,064	127.45
FBB	11-Feb-88	14-Feb-89	16Feb-89	19-Feb-88	8,800	6,805	126.03
Total					35,825	27,717	126.62

Date	Yan/USS	Yen LIBOR	(1 year)	Forward Rateb
08-Feb-88	129.25	4.2500	7.1875	125.71
12-Feb-88	129.70	4.1250	7.0625	126.14
17-Feb-88	130.35	4.3125	7.3125	126.71
21-Feb-88	128.85	4.2500	7.1250	125.39

CASE EXHIBIT 7.2 Summary of Results from the Option Loans Daewoo wrote yen-put/dollar-call options and sold the yen forward against the dollar.

Source	Amount	Contract	Delivery	Rate(V/USS)	Receivable
SFCB	5 billion	17-May-88	10-Feb-89	122.46	$ 40,828,000
FGB	5 billion	25-May-88	14-Feb-89	124.66	$ 40,108,000
FGB	5 billion	28-May-88	17-Feb-89	125.45	$ 39,856,000
FBB	5 billion	01-Nov-88	16-Feb-89	123.98	$ 40,328,000
Total	20 billion			124.14	$161,120,000

The option contracts involved contingent exposures denominated in the Japanese yen, which on maturity Daewoo could receive in exchange for the U.S. dollar (see Case Exhibit 7.2). Hedging the exposures would simply involve selling yen forward to match the Japanese yen bought on the option contracts. Still, Mr. Ahn felt that he should not hedge his yen position immediately. Indeed, since the Plaza Accord of September 1985, the U.S. dollar had steadily depreciated against the Japanese yen and the major European currencies. Many people had expected the dollar to continue its depreciation, breaking the 120/US$ level in a few months. When the option contracts were written, the dollar rebounded to 129/US$ from its record low of just above 120/US$ in early January. Personally, Mr. Ahn strongly believed that the dollar would still come back down below 120/US$ and that would be the time at which he should hedge. Because of this and his belief that the Japanese yen was the strongest currency at the time in terms of expected appreciation, he decided to write yen-put/dollar-call options. Mr. Ahn even thought that the U.S. dollar could fall as low as 100/US$1 by the time the options matured. This was the second reason he did not hedge his yen

position immediately. If the dollar did fall that low, forward contracts for the pur- pose of hedging would turn out to be a big loss since the options would be left unex- ercised. The last reason for leaving his exposure unhedged was to guard against the

possibility that South Koreas Offi ce of Bank Supervision and Examination (OBSE)

would recognize the deal for what it was. OBSE was very emphatic about its dis- like for any disguised foreign currency loans, and several previous deals had been

denounced as such. The option loans had a good chance of being found out, and if they were hedged with forwards, there would be no excuse available. However, by leaving them open, Mr. Ahn could disclose them as hedging instruments for different exposures. After signing the option contracts, Mr. Ahn had his dealers submit to the three banks documents substantiating the evidence of real demand. An export license (E/L) was submitted to SFCB representing the shipment of US$63 million worth of Le Mans passenger cars to be delivered to the Pontiac division of General Motors. To both FGB and FBB, a license issued by the Korean Exchange Bank for overseas construction works in Africa amounting to US$420 million was submitted. Both the export and construction contracts were denominated in U.S. dollars and were

in no way connected to the Japanese yen. Even so, the E/L and the license for over- seas construction works effectively served to provide proof of real demand for the

yen-dollar option contracts. Soon afterward, SFCB sent notice to Daewoo that its lawyers had approved the E/L as an appropriate document. As there were no stated

defi nitions of the nature of functional currencies or accounting currencies in the For- eign Exchange Control Regulations, Daewoo could claim that the transactions were

simply a conversion of receivables denominated in the weak dollar into the stronger yen through the use of option contracts. As it turned out, the OBSE had previously accepted similar claims in past examinations of foreign banks. After Daewoo successfully completed writing the options with the three banks, market activity suddenly fl ared up, with many companies following Daewoos path

by structuring option contracts very similar to the option-loan scheme. Indeed, Dae- woo had engineered an ingenious way of raising fi nancing now and not worrying

about its true cost until much later!

QUESTIONS FOR DISCUSSION

1. What are deep-in-the money currency options? Why is writing deep-in-the- money currency options tantamount to short-term fi nancing?

2. What were the mechanics for Daewoo of writing deep-in-the-money yen-put/ dollar-call options? 3. Under what exchange rate scenario is the option loan interest-free? What was Daewoos cost of fi nancing?

4. How would you measure the exposure incurred by Daewoo in writing deep-in- the-money options?

5. How should Daewoo hedge itself? How would it impact the fi nancing cost?