Case Study

ZEEP plc has recently decided to expand its international trade relationship by exporting to the United States. Jogs Inc a US retailer, has committed itself to the annual purchase of 180 000 pairs of 'Speedos', Zeep' primary product, for a price of $75 per pair. The agreement is to last for two years, at which time it may be renewed by ZEEP plc and Jogs. In addition to this new international trade relationship, ZEEP plc continues to export to Thailand. Its primary customer there, a retailer called Entertainment Products, is committed to the purchase of 160 000 pairs of Speedos annually for another two years at a fixed price of 3194 Thai baht per pair. When the agreement terminates, it may be renewed by ZEEP plc and Entertainment Products. ZEEP plc also incurs costs of goods sold denominated in Thai baht. It imports materials sufficient to manufacture 72 000 pairs of Speedos annually from Thailand. These imports are denominated in baht, and the price depends on current market prices for the rubber and plastic components imported. Under the two export arrangements, ZEEP sells quarterly amounts of 45 000 and 40 000 pairs of Speedos to Jogs and Entertainment Products, respectively. Payment for these sales is made on the first of January, April, July, and October. The annual amounts are spread over quarters in order to avoid excessive inventories for the British and Thai retailers. Similarly, in order to avoid excessive inventories, ZEEP plcusually imports materials sufficient to manufacture 18 000 pairs of Speedos quarterly from Thailand. Although payment terms call for payment within 60 days of delivery, ZEEP plc generally pays for its Thai imports upon delivery on the first day of each quarter in order to maintain its trade relationships with the Thai suppliers. ZEEP plc feels that early payment is beneficial, as other customers of the Thai supplier pay for their purchases only when it is required. Since ZEEP is relatively new to international trade, Chris Pelmet,Zeep ' chief financial officer (CFO), is concerned with the potential impact of exchange rate fluctuations on Zeep' financial performance. Chris is vaguely familiar with various techniques available to hedge transaction exposure, but he is not certain whether one technique is superior to the others. Chris would like to know more about the forward, money market, and option hedges and has asked you, a financial analyst at Zeep, to help him identify the hedging technique most appropriate for Zeep. Unfortunately, no options are available for Thailand, but dollar call and put options are available for $25 000 per option.

Chris Pelmet has gathered and provided you with the following information for Thailand and the United States:

Thailand

(b

Tailand Baht

US $

Current spot rate

0.0153

0. 56

90-day forward rate

0.0143

0.575

Put option premium

Not available

0.023 per unit

Put option exercise

price

Not available

0.59

Call option premium

Not available

0.030 per unit

Call option exercise

price

Not available

0.63

90-day borrowing

rate (nonannualized)

3.5%

1.5%

90-day lending rate

(non-annualized)

2.5%

1.8%

In addition to this information, Chris Pelmet hasinformed you that the 90-day borrowing and lendingrates in the United States are 2.2% and 2.5%, respectively,on a non-annualized basis. He has also identifiedthe following probability distributions for theexchange rates of the British pound and the Thai bahtin 90 days:

Probability

Spot rate for Dollar in 90 days

Spot Rate for the Thai Baht in 90 days

2.5%

0.570

0.0152

25

0.565

0.0156

35

0.561

0.0159

30

0.559

0.0160

5

0.558

0.0165

2.5

0.556

0.0169

90 Days

Zeep' next sales to and purchases from Thailand will occur one quarter from now. If ZEEP decides to hedge, Chris will want to hedge the entire amount subject to exchange rate fluctuations, even if it requires overhedging (i.e., hedging more than the needed amount). Currently, Chris expects the imported components from Thailand to cost approximately 5000 baht per pair of Speedos. Chris has asked you to answer the following questions for him:

Questions

Using a spreadsheet, compare the hedging alternatives for the Thai baht with a scenario under which ZEEP remains unhedged. Do you think ZEEP should hedge or remain unhedged? If ZEEP should hedge, which hedge is most appropriate?