Question
Discussion Questions for Pixonix Inc. Addressing Currency Exposure: Explain why Cain is concerned by the current exchange rate fluctuations. Also, determine whether her position is
Discussion Questions for Pixonix Inc. Addressing Currency Exposure:
- Explain why Cain is concerned by the current exchange rate fluctuations. Also, determine whether her position is long or short. Explain.
- If Cain decides to use options, explain and justify whether she would use calls or puts.
- Calculate the impact of the two hedging strategies and the unhedged position under the following three scenarios at the end of January:
- US$1 = CAD$1 , 2. US$1 = CAD$0.90, 3. US$1 = CAD$1.10 , For simplification, you can ignore the differences in time values over the 3-month period. 4- 4.Discuss whether Cain should hedge her position in the US dollars. Explain why or why not. If you think she should hedge, then determine the best hedging vehicle she should use. Explain and discuss. Note: If you decide to use options, then please specify the exercise (strike) price.
On Friday November 2, 2007, Mikayla Cain, chief financial officer of Pixonix Inc., sat in her office and pondered the impact of the strong Canadian dollar on her firms projected financial results. The Report on Business today stated that the Canadian dollar had hit another record, jumping to US$1.0717 from the previous days close of $1.0512 after a stronger-than-expected jobs report reduced the odds of an interest- rate cut. The Canadian dollar had already been the worlds best-performing major currency this year, increasing 25 per cent against the U.S. dollar and almost seven per cent in the past month alone. Cain knew she would have to understand the impact of the strong dollar on her firms cash flows and the tools available to manage the companys currency risk.
THE COMPANY
Pixonix was a graphic design company that operated in Toronto, Canada. At an annual cost of US$7.5 million, the company licensed proprietary tools and software through a U.S. company; this payment was due at the end of January each year. While all of the companys revenues were denominated in Canadian dollars, a significant portion of its expenses were paid in U.S. dollars. Therefore, Pixonix had to annually convert its Canadian dollar cash flows into U.S. dollars. As the Canadian dollar strengthened, cash flow and profitability had been positively impacted, but Cain faced a considerable amount of uncertainty about the value of the Canadian dollar at the end of January, when she would have to purchase US$7.5 million. RECENT HISTORY OF THE CANADIAN DOLLAR :At times during the early 1970s, the value of the Canadian dollar was higher than that of the U.S. dollar, reaching a high of US$1.0443 on April 25, 1974. During the technological boom of the 1990s, the Canadian dollar fell relative to the U.S. dollar and traded at a record low of US$0.6179 on January 21, 2002. Since then, its value had risen, in part due to the high price of Canadas commodity exports (primarily oil). The Canadian dollars value against the U.S. dollar rose sharply in 2007, owing to the continued strength of the Canadian economy and the U.S. currencys recent weakness. On September 26, 2007, the Canadian dollar was trading at parity with the U.S. dollar for the first time since November 25, 1976. On September 28, 2007, the Canadian dollar closed above the U.S. dollar for the first time in 30 years and had today hit an all-time high since official record-keeping began. RBC, the largest international trader of Canadian dollars, raised its forecast for the currency on Friday, saying it would appreciate further to around US$1.08 before declining below parity in the second half of next year. HEDGING VEHICLES: Cain had investigated various vehicles for hedging the companys foreign exchange risk, including call options, put options and forward contracts. An option is a financial contract between two parties, the buyer and the seller (referred to as the writer) of the option contract. The buyer of the option has the right, but not the obligation, to buy or sell a pre- determined quantity of a particular security (or other financial asset) at a certain time for a pre-determined price (the strike price). The buyer pays a fee (premium) for this right, and risk is limited to the premium paid. Exact specifications differ depending on the type of option. A European option allows the holder to exercise the option only on the expiration date, while an American call option allows exercise at any time during the life of the option. A call option allows the buyer to purchase a particular asset, and the seller is contractually obligated to sell the asset should the buyer choose to exercise his/her right to purchase. The buyer of the call option believes that the price of the underlying asset will rise (bullish outlook), whereas the seller believes that the price of the asset will fall (bearish outlook). Call options increase in value when the underlying instrument increases in value. When the price of the underlying instrument is greater than the strike price, the option is said to be in the money. When the price of the underlying instrument is less than the strike price, the option is said to be out of the money. A put option allows the buyer to sell a particular asset, and the seller is contractually obligated to buy the asset should the buyer choose to exercise his/her right to sell. The buyer of the put option believes that the price of the asset will fall (bearish outlook), whereas the seller believes that the price of the asset will rise (bullish outlook). Put options increase in value when the underlying instrument decreases in value. When the price of the underlying instrument is less than the strike price, the option is said to be in the money. When the price of the underlying instrument is greater than the strike price, the option is said to be out of the money. A forward contract is a contractual agreement between two parties to buy or sell an asset at a pre-agreed future point in time at a pre-determined price. Forwards are typically used to control and hedge risk. In this particular contract, one party agrees (is obligated to) to sell and the other party is obligated to buy; the exercise of a forward contract is not optional. The forward price of the contract is typically compared to the spot price for the asset, which is the price at which the asset currently trades. The difference between the spot and the forward price is typically referred to as the forward premium or forward discount. A standardized forward contract that trades on an exchange is referred to as a futures contract. POTENTIAL STRATEGIES: Cain had two strategies in mind to address the firms currency exposure. The first strategy (herein referred to as Strategy 1) that Cain was considering was to purchase a forward contract and lock in the cost of the January U.S. dollar purchase of US$7 million. See Exhibit 1 for the current forward rate on the U.S. dollar. A second strategy (herein referred to as Strategy 2) would be for Cain to purchase a U.S.-dollar call option for $7.5 million. The result of this strategy would be to set an upper limit on the cost of her January purchase of U.S. dollars. See Exhibit 2 for the current premiums on various U.S. dollar call and put options. CONCLUSION : Cain was unsure about which hedging strategy to use. She was interested to see the impact of her hedging strategies under different exchange rates.
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