Eric Chan, Marys boss, was going to ask her to find some ways to improve the profit situation. The interim financial statements had shown that for the fourth quarter in a row, The China Pipe Company had reported a sharp drop in earnings per share despite a consistent increase in revenues. Needless to say, the shareholders and the Board of Directors were unhappy and the fund managers inquired about 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, David Li.

The China Pipe Company was headquartered in Anhui and had established manufacturing facilities in Jiangsu, Zhejiang, Fujian, and Guangdong. It specialized in the manufacture of high-grade copper piping of various thickness and circular dimensions. The pipes were used primarily in commercial and residential applications. Over 60% of its sales were for exports to the EURO zones while the rest came from sales to wholesalers in China.

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 (USD3.68/lb.). That was the price that had been figured into the cost structure. Unfortunately, due to the intense competition of the piping industry, China Pipe was unable to charge a higher price to the wholesalers. On the other hand, the RMB had strengthened significantly over the prior twelve months resulting in loss of profits upon conversion of EURO into RMB. The RMB had gone from EURO 0.10 per RMB, twelve months ago, to its current level of EURO 0.12 per RMB. Due to the fierce competition in the overseas market, EURO zones wholesalers were able to negotiate very favorable terms including ninety days credit and payment in EURO.

Table 1

Historical Spot Prices of High-Grade Copper
Month end		Price (USD/lb.)
March	20x0	3.68
April	20x0	3.84
May	20x0	3.93
June	20x0	3.90
July	20x0	3.99
August	20x0	3.83
September	20x0	3.67
October	20x0	4.18
November	20x0	4.24
December	20x0	4.35
January	20x1	4.42
February	20x1	4.52

Part of the problem at China Pipe was that the previous CFO, David Li, had not been very familiar with the idea of risk management and the working of derivatives. He had therefore not hedged the companys commodity and exchange rate exposures at all. Upon Davids retirement, Eric Chan, was appointed as the CFO. Erics first move was to recruit Mary Lam, a derivatives expert. Mary had earned an MBA with concentration in Finance at the University of Chicago and had worked for five years at the Chicago Mercantile Exchange, prior to joining China Pipe. The company had made her a generous offer that was too good to resist and Mary knew that sooner or later the pressure would be on to prove her worth.

In preparation for the meeting with Eric, Mary gathered information from the purchasing, sales, payables, and receivables departments. The sales department had booked orders for EURO 50 million worth of pipes from EURO zones clients. Mary estimated that the company would need about 10 million pounds worth of high-grade copper by the end of three months to manufacture the pipes. Copper was being quoted at USD 4.28 per pound in the spot market and the EURO was quoted at EURO 0.12 per RMB. There was a possibility that copper prices could go down and the RMB could weaken against the EURO, but the reverse could also happen. Mary knew all too well that the market could go either way and remembered vividly what his prior boss used to often say, Hedge when it is uncertain and stabilize the cash flow. She feared that if copper prices were to appreciate along with the RMB, corporate profits would be significantly affected and she would be out looking for a job. She admired this company and the generous compensation package she had been offered was definitely worth keeping. I had better come up with some effective hedging combinations, thought Mary. This is no time to take a wait and see approach.

Mary surfed through the Internet for the latest quotes on futures contracts trading on the RMB/EUR and on high-grade copper (see Tables 2-5). After written down some numbers and making some quick calculations, Mary picked up the phone. Eric, she said with a cheer voice, About that meeting you wanted to have with mecan we meet right away?

Table 2

RMB/EUR Futures Contract specifications
Trading unit:	1,000,000 Chinese renminbi
Price Quotation:	EURO per RMB
Trading symbol:	RMB/EUR

Table 3

RMB/EUR Futures

Settlement prices as of February 20x1

MTH/	----DAILY----				----PRIOR DAY----
STRIKE	OPEN	HIGH	LOW	LAST	CHG	SETT	VOL.	OPEN INT.
MARx1	0.12213	0.12215	0.12200	0.12200	+120	0.12219	12	209
JUNx1	0.12295	0.12295	0.12295	0.12295	+150	0.12249	1	140

Table 4

Copper Futures Contract specifications
Trading unit:	25000 lbs.
Price Quotation:	USD per lb.
Trading symbol:	HG

Table 5

Copper Futures

Settlement Prices as of February 20x1

CONTRACT	TODAYS SETTLE	DAILY HIGH	DAILY LOW
HG 02 x1	4.2735	4.3135	4.2705
HG 03 x1	4.2755	4.3475	4.2500
HG 04 x1	4.2840	4.3440	4.2585
HG 05 x1	4.2975	4.3630	4.2650
HG 06 x1	4.3010	4.3390	4.2900
HG 07 x1	4.3045	4.3595	4.2760
HG 08 x1	4.3050	4.3450	4.2990
HG 09 x1	4.3100	4.3630	4.2895

Required:

1.	What is meant by the term transactions exposure? What kind of transaction exposure is the China Pipe faced with?
2.	How much variability has there been in the spot price of high-grade copper over the past twelve months? Is it large enough to warrant the need for hedging? Please explain.
3.	What kind of hedging strategy should Mary recommend for minimizing China Pipes exposure to volatility in copper prices? Design a suitable hedge and show what would be the result if copper prices went to USD 4.60 per lb. at the end of three months when the company would be ordering the high-grade copper.
4.	How should Mary respond if Eric argues that there is a good chance that copper prices could be coming down?
5.	Why is Mary concerned about the RMB strengthening in value against the EURO?
6.	What hedging strategies can Mary recommend to minimize the impact of exchange rate volatility?
7.	Using the data given for RMB/EUR futures contracts design a suitable hedge that would minimize China Pipes exposure to fluctuations in the exchange rate between the RMB and the EURO. Explain the results of the hedge if by June 20x1, when payment is received from the EURO zones wholesalers, the exchange rate goes to EURO 0.135 per RMB.
8.	Eric questions Mary, What other strategies could the company use to hedge against the exchange rate exposures? How should Mary respond?