Daniel Marks, the chief financial officer of Stark Supply Co, has met with James Grom, vice president of the International Division of First Mississippi Bank on the morning of February 15, 2018.The meeting has focused on the foreign exchange risk related to a new contract to purchase from a new supplier in Switzerland.This is Stark's first large purchase from an international supplier. Stark has contracted (in December 2017) to purchase a large shipment of cowbells for SF 1,100,000.In accordance with the contract, Stark has transferred SF 100,000 to the Swiss firm as a deposit on the contract on January 18, 2018.The Swiss firm has agreed to deliver the cowbells on February 20, 2018 and payment of SF 1,000,000, the balance due, is to be made May 16, 2018.

History of Stark

Stark has been a supplier of distinctive products to a variety of small retailers in Mississippi, Tennessee, Alabama, Arkansas and Louisiana for over 30 years.Stark does not manufacture any products.It has generally sourced the products it sells from its suppliers in the United States and Mexico.Until now all of Stark's suppliers have been paid with U.S. dollars.

Because of increasing competition and negative operating income from 2008-2013, Stark has diversified its set of suppliers.From 2014-2017, this strategy has helped Stark generate small but positive operating income.In spite of the improvement in operating income, directors of Stark remain disappointed with the company's performance and this has led management to look for new suppliers in other parts of the world.Some of Stark's management believe that a more diverse set of suppliers, international suppliers in particular, will enable the company to become more competitive with the new entrants into its markets and improve its operating income. However, the CEO of Stark, Hunter Paul is concerned with the foreign exchange risk associated with using suppliers from outside North America and is skeptical that this could result in improved operating income for the company.

This is Stark's first purchase involving foreign currency.Hunter Paul has observed that the Swiss Franc has appreciated since December and has directed Daniel Marks to fully investigate how the company could manage the foreign exchange risk associated with this large purchase.

Foreign Exchange Risk

On 12/14/2017, the day that Stark placed the order for cowbells from the Swiss company, the exchange rate for the Swiss Franc is $1.010094. However, the Swiss Franc has appreciated 7.22% since then. Marks is concerned that the Swiss Franc could continue to appreciate even more in the coming weeks, and it is this concern that has prompted discussion with First Mississippi Bank. Marks wants to learn what techniques are available to Stark to reduce the foreign exchange risk associated with the Swiss Franc payable.

Grom, the international specialist with the bank, explains that Marks has several alternatives. First, he could do nothing and remain unhedged. This would leave Stark vulnerable to Swiss Franc fluctuations which would entail greater cost measured in dollars if the Swiss Franc appreciates or lower cost measured in dollars if the Swiss Franc depreciates. Alternatively, Marks could choose to hedge the foreign exchange risk.

Grom explains that a hedge involves taking a position opposite to the one creating the foreign exchange risk exposure.This could be accomplished by a futures contract, a forward contract, or a spot transaction. Since Stark has an outstanding Swiss Franc payable, the appropriate hedging transactions would be to buy a Swiss Franc futures contract, buy Swiss Francs forward 90 days or secure a 90-day dollar loan using the proceeds now to buy Swiss Francs in the spot market. By buying either a SF futures contract or buying SF forward, Stark would create an obligation to buy SF at a rate established in the market today.Since obligated to buy Swiss Francs at an established rate, the value of this obligation increases as the Swiss Franc appreciates.This would hedge Stark's Swiss Franc payable, which becomes more costly, measured in dollars, as the Swiss Franc appreciates.

Futures contracts are traded on an exchange and there are a limited number of maturity dates available.Also, futures contracts are marked to market. Marking to market means that if Stark buys a Swiss Franc futures contract, each trading day there would be losses if the Swiss Franc (SF) depreciates and profits if the SF appreciates. Also, there is no May 16, 2018 maturity futures contract, so Grom advises Marks that he would need to purchase a June 18, 2018 maturity futures contract. When Stark must make its payment to its Swiss supplier, it will need to buy Swiss Francs in the spot market at that time(at the spot rate on May 16) and sell a Swiss Franc futures contract (with June 18 maturity date) offsetting its original long Swiss Franc futures contract. Grom explains that on May 16 both the spot rate and the futures price (June 18 maturity contract) would be established in the market on May 16.There is still some small amount of risk, called basis risk, because the difference between the spot rate on May 16 and the futures price on a futures contract written on May 16 is not known until May 16.Grom explains that there would be some basis risk because futures contracts are traded on an exchange, only a limited number of maturity dates are available, and Stark would have to buy a contract with a longer time to maturity than the date of the payable. The contract would be offset on the date of the payable (May 16) and Swiss Francs would be purchased in the spot market. Although convinced that the basis risk would be small, Marks is concerned about the potential negative cash flow associated with the futures contract, if the Swiss Franc depreciates. Since the company is concerned about losses, he thought he would have a difficult time explaining potential losses on the futures contract, even though they would be offset by gains from the reduction of the dollar cost of the payable.

Grom suggests a forward contract rather than a futures contract.The forward contract would not be traded on an exchange and would not be marked to market.Also, the contract could be written so that the maturity date coincides with the date of the payable (in this case May 16, the date the Swiss Franc payment must be made).This would eliminate any basis risk, since the forward contract with maturity date May 16 obligates the buyer of the contract to buy Swiss Francs on May 16 at the forward rate established when the contract is written. Those Swiss Francs would then be used to make the SF payable.This would mean that Stark would know exactly how many dollars it would need to make the Swiss Franc payable. The number of dollars it would need would be determined by the forward rate on the contract written on February 15, 2018.The forward rate is therefore known on February 15 and thus, there is no foreign exchange risk. Grom informs Marks that on February 15, the forward rates (bid and ask) for a SF forward contract with May 16 maturity are Bid: $1.0915 and Ask: $1.0925

The spot hedge works similarly in that it creates a long position in Swiss Francs in 90 days.Stark would borrow dollars from First Mississippi Bank and exchange the proceeds into Swiss Francs at the spot rate. First Mississippi Bank would then arrange to have the Swiss Francs deposited in a Swiss bank. First Mississippi Bank would lend dollars at 4% per annum (1.0% for 90 days) and the Swiss bank pays interest on large SF deposits at 2% (0.50% for 90 days).The Swiss Francs would be withdrawn from the Swiss bank to make the payable on May 16.

Grom assures Marks that First Mississippi Bank would assist Stark to execute whatever decision Marks makes.To help Marks make his decision, Grom provides Marks with historical information on direct quotes for the Swiss Franc (see exhibit 1).

Marks calculates that Stark could pay a total of $1,300,000 (includes January deposit plus balance due in May) for this order of cowbells and still break-even on the order. Using the spot rate on December 14, 2017 when the order was placed, to calculate the dollar cost of the order (note this assumes an unchanged exchange rate for the Swiss Franc), this would mean a nearly 15% profit margin or a profit of approximately $188,900.In December, Marks thought that this would be a sufficient margin to both develop an important supplier in Switzerland yet still convince Hunter Paul and the Stark directors of the wisdom of purchasing from international suppliers.

Marks realizes that the large size of the contract could cause Stark Supply Co. to return to negative operating income for 2018 if Stark remains unhedged and the Swiss Franc continues to appreciate.However, if Stark remains unhedged and the Swiss Franc depreciates, he might still be able to achieve the 15% profit margin he had originally forecasted. Grom suggested to Marks that remaining unhedged could give the appearance that Marks is speculating on the value of the Swiss Franc. Alternatively, Stark could hedge the foreign exchange risk. Marks is aware that hedging could also be unfavorable for Stark. Thus, Marks has a critical decision to make.

1. If Stark uses the spot transaction (also known as a money market hedge) suggested in the case, how many Swiss Francs does Stark purchase in the spot market on February 15, 2018 and how many dollars does Stark borrow from the bank on February 15, 2018 to pay for the Swiss Francs that Stark purchases?

Note that the spot rate on May 16 is unknown at the time Stark makes its hedging decision on Feb 15, 2018. Stark's objective is to not have to trade in the spot market on May 16, 2018. There is no foreign exchange risk if it is unnecessary for Stark to buy or sell Swiss Francs on May 16 at the spot rate.