Problem:

In early June of 2006, Doug Parker met with his sales manager Elisa Blanco to discuss the results of a recent foray into international markets. This was new territory for Parker Adhesives, a small company manufacturing specialty adhesives. Until a recent sale to Jogo, a Brazilian toy manufacturer, all of Parker Adhesives' sales had been lo companies not far from its Newark, New Jersey, manufacturing facility. As US manufacturing continued to migrate overseas, however, Parker would be under intense pressure to find new markets, which would inevitably lead to international sales. Doug Parker was looking forward to this meeting. The recent sale to Jogo, while modest in size at 1,210 gallons, had been a significant financial boost lo Parker Adhesives. The order had used up some rawmaterials inventory that Parker had considered reselling at a loss a few months before the Jogo order. Furthermore, the company had been running well under capacity and the order was easily accommodated within the production schedule. The purpose of the meeting was to finalize details On a new order from Jogo that was to be 50% larger than the original order. Also, payment for the earlier Jogo order had just been received and Parker was looking forward to paying down some of the balance on the firm's line of credit. As Parker sat down with Moreno, he could tell immediately that he was in for bad news. It came quickly. Blanco pointed out that since the Jogo order was denominated in Brazilian real (BRL), the payment from Jogo had to be converted into U.S. dollars (US$) al the current FX rate. Given FX-rate changes since the time BA and Jogo had agreed on a per-gallon price, the value of the payment was substantially lower than anticipated. More disappointing was the fact that Jogo was unwilling to consider a change in the pergallon price for the follow-on order. Translated into dollars, therefore, the new order would not be as profitable as the original order had initially appeared. In fact, it would not even be as profitable as the original order had turned out to be due to a rise in some of Parker Adhesives' costs.

Adhesives Market:

The market for adhesives was dominated by a few large firms that provided the vast bulk of adhesives in the United States and in global markets. The adhesives giants had international manufacturing and sourcing capabilities. Margins on most adhesives were quite slim since competition was fierce. In response, successful firms had developed ever more efficient production systems which, to a great degree, relied on economies of scale. The focus on scale economies had left a number of specialty markets open for small and technically savvy firms. The key to success in the specialty market was not the efficient manufacture of large quantities, but figuring out how to feasibly and economically produce relatively small batch with distinct properties. In this market, a good chemist and a flexible production system were key drivers of success. Parker Adhesives had both. The business was started by Doug Parker's father, a brilliant chemist who left a big company to focus on the more interesting, if less marketable, products that eventually became the staple of Parker Adhesives product line. While Parker's father had retired some years ago, he had attracted a number of capable new employees, and the company was still an acknowledged leader in the specialty markets. The production facilities, though old, were readily adaptable and had been well maintained. Until just a few years earlier. Parker Adhesives had done well financially. While growth in sales had never been a strong point, margins were generally high and sales levels steady. The company had never employed long-term debt and still did not do so. The firm had a line of credit from a local bank, which had always provided sufficient funds to cover short-term needs. Parker Adhesives presently owed about $180.000 on the credit line. Parker had an excellent relationship with the bank, which had been with the company from the beginning.

Jogo Orders:

The original order from Jogo was for an adhesive Jogo was using in the production of a new line of toys for its Brazilian market. The toys needed to be waterproof and the adhesive, therefore, needed very specific properties. Through a mutual friend, Blanco had been introduced to Jogos purchasing agent. Working with Doug Parker, she had then negotiated the original order in February (the basis for the pricing of that original order is shown in Exhibit 1). Jogo had agreed to pay shipping costs, so Parker Adhesives simply had to deliver the adhesive in 55 gallon drums to a nearby shipping facility. The proposed new order was similar to the last one. As before, Jogo agreed to make payment 30 days after receipt of the adhesives at the shipping facility. Parker anticipated a five-week manufacturing cycle once all the raw materials were in place. All materials would be secured within two weeks. Allowing for some flexibility, Blanco believed payment would be received about three months from order placement; that was about how long the original order took. For this reason, Blanco expected receipt of payment on the new order, assuming it was agreed upon immediately, somewhere around September 5, 2006. Whereas one-third of the raw materials continued to be materials Parker Adhesives had in excess supply (those the company had considered selling off) and the rest were on hand, about a quarter of the materials needed to be purchased, and their cost had recently risen by 10%.

Exchange Risks:

With her newfound awareness of FX-rate risks, Blanco had gathered additional information on FX-rate markets before the meeting with Doug Parker. The history of the dollar-to-real FX rate is shown in Exhibit 2. Furthermore, the data in that exhibit provided the most recent information on money markets and an estimate of the expected future (September 5. 2006) spot rates from a forecasting service. Blanco had discussed her concerns about FX-rate changes with the bank when she had arranged for conversion of the original Jogo payment. 1 The bank, helpful as always, had described two ways in which Parker could mitigate the FX risk from any new order: hedge in the forward market or hedge in the money market.

Hedge in the Forward Market:

Banks would often provide their clients with guaranteed FX rates for the future FX of currencies (forward rates). These contracts specified a date, an amount to be exchanged, and a rate. Any bank fee would be built into the rate. By securing a forward rate for the date of a foreign-CCY-denominated CF, a firm could eliminate any risk due to CCY fluctuations. In this case, the anticipated future inflow of real from the sale to Jogo could be converted at a rate that would be known today.

Hedge in the Money Markets:

Rather than eliminate FX risk through a contracted future FX rate, a firm could make any CCY FXs at the known current spot rate. To do this, of course, the firm needed to convert future expected CFs into current CFs. This was done on the money market by borrowing "today" in a foreign CCY against an expected future inflow or making a deposit "today" in a foreign account so as to be able to meet a future outflow. The amount to be borrowed or deposited would depend on the interest rates in the foreign CCY because a firm would not wish to transfer more or less than what would be needed. In this case, Parker Adhesives would borrow in real against the future inflow from Jogo. The amount the company would borrow would be an amount such that the Jogo receipt would exactly cover both principal and interest on the borrowing. After some discussion and negotiation with the bank and bank affiliates, Blanco was able to secure the following agreements: Parker Adhesives bank had agreed to offer a forward contract for September 5. 2006, at an FX rate of 0.4227 USS/BRL. An affiliate of the bank, located in Brazil and familiar with Jogo, was willing to provide Parker with a short-term real loan, secured by the Jogo receivable at 26% Blanco was initially shocked at this rate, which was more than three times the 8.52 % rate on Parker's domestic line of credit: however, the bank described Brazil's historically high inflation and the recent attempts by the government to control inflation with high interest rates. The rate they had secured was typical of the market at the time.

The Meeting:

It took Doug Parker some time to get over his disappointment. If international sales were the key to the future of Parker Adhesives, however, Parker realized he had already learned some important lessons. He vowed to put those lessons to good use a Blanco turned their attention to the new Jogo order. 2Note that the loan from the bank affiliate was a 26% annual percentage rate for a three-month loan (the bank would charge exactly 6.5% on a three-month loan, to be paid when the principle was repaid. The effective rate over three months was, therefore. 6.5%. The 8.52% rate for Parker's line of credit was an annual percentage rate based on monthly compounding. The effective monthly rate was, therefore, 8.52% / 12 = 0.71 %, which implies a (I.0071)3 - I = 2. 1452% effective rate over three months.

Question 3:

. Are the money markets and forward markets in parity?