STARK SUPPLY CO. (A)

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 Starks 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.

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 Starks 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.

Stark would in fact be a hedger, since it would have both the payable and the futures contract. One position improves and one worsens as the Swiss Franc appreciates or depreciates. However, taken by itself, the futures contract appears to be speculation as there would be cash flow implications with the futures contract. Marks was very concerned that either positive profits (if the SF appreciates) or losses (if the SF depreciates) associated with the futures contract could lead Stark directors to order him to offset the futures contract resulting in Stark becoming unhedged. Both the complexity with the futures contract, the basis risk, and the cash flow implications raise concern for Marks, leading Marks to ask to examine alternatives.

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.

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.

Exhibit 1
Historic Data: Exchange Rate for the Swiss Franc
Date	Dollars/SF
2/15/18	$1.083038
2/8/18	$1.065833
2/1/18	$1.076810
1/25/18	$1.069083
1/18/18	$1.043349
1/11/18	$1.025718
1/4/18	$1.025168
12/28/17	$1.023050
12/21/17	$1.010999
12/14/17	$1.010094
12/7/17	$1.007947
11/30/17	$1.016707
11/23/17	$1.018330
11/16/17	$1.007712
11/9/07	$1.004228
11/2/17	$1.002424
10/26/17	$1.004820
10/19/17	$1.025701
10/12/17	$1.024786
10/5/17	$1.021210
9/28/17	$1.029953
9/21/17	$1.031891
9/14/17	$1.035185
9/7/17	$1.052609
8/31/17	$1.040740
8/24/17	$1.036957
8/17/17	$1.037990
8/10/17	$1.036288
8/3/17	$1.032129
2/23/17	$0.993684
8/25/16	$1.032411
2/25/16	$1.010738
8/27/15	$1.038379
2/26/15	$1.048101
8/28/14	$1.092793
2/27/14	$1.126196
8/29/13	$1.073461
2/28/13	$1.071097
2/23/12	$1.103917
2/24/11	$1.080777
2/25/10	$0.920988
2/26/09	$0.858375
2/28/08	$0.921608

The following are the questions that go with the (A) Case:

1a. What is the dollar cost of the deposit payment made on January 18, 2018?

Note that this payment is made prior to February. This cost remains unchanged regardless of the Starks hedging choice.

b. There are four parts to this question. Note that the futures price on May 16, 2018 for a June 18, 2018 maturity Swiss Franc futures contract and the spot price on May 16, 2018 for the Swiss Franc are both unknown on February 15, 2018.

a. Suppose the futures price on May 16 for a June 18 contract is $1.02 and the spot price on May 16 is $1.025. What is Starks total dollar cost if Stark hedges with a futures contract and the futures price on February 15 for a June 18 contract is $1.09?

When you calculate total dollar cost include the dollar cost of the deposit payment (calculated in question 1), the profit/loss on the futures contract, and the payment to purchase Swiss Francs in the spot market on May 16. If there is a profit/loss on the futures contact, multiply the profit/loss by -1 when calculating cost since a positive profit would represent a negative cost.

As described in the Case, the long futures contract that Stark enters into on February 15 is offset with a short futures contract on May 16. Given marking to market, Stark realizes all profits/losses associated with the long futures contract by May 16 when the contract is offset. Once the contract is offset there are no future profits or losses.

b. Suppose the futures price on May 16 for a June 18 contract is $1.15 and the spot price on May 16 is $1.148. What is Starks total dollar cost if Stark hedges with a futures contract and the futures price on February 15 for a June 18 contract is $1.09?

When you calculate total dollar cost include the dollar cost of the deposit payment (calculated in question 1), the profit/loss on the futures contract, and the payment to purchase Swiss Francs in the spot market on May 16. If there is a profit/loss on the futures contact, multiply the profit/loss by -1 when calculating cost since a positive profit would represent a negative cost.

As described in the Case, the long futures contract that Stark enters into on February 15 is offset with a short futures contract on May 16. Given marking to market, Stark realizes all profits/losses associated with the long futures contract by May 16 when the contract is offset. Once the contract is offset there are no future profits or losses.

c. Briefly explain why your answers to parts A and B are similar but not identical?

d. Recall that Stark had originally assumed a constant exchange rate for the Swiss Franc and therefore, forecasted on December 14, 2017 a profit on the cowbells of approximately $188,900. If Stark breaks-even at a cost of $1,300,000, what is Starks profit on the cowbells hedging with a futures contract? Compare profit to the profit Stark had originally forecasted.

Since Stark breaks-even at a cost of $1,300,000, subtract total dollar cost from $1,300,000 to calculate profit on the cowbells.

Note that you should provide two answers: one answer corresponds to the assumptions in part A above and the second answer corresponds to part B above.