Vanguard Security Corporation:

International Transaction Dilemma

A late spring day was dawning as Peter Levin, Vanguard Security Corporations treasurer, arrived at the office

to meet with his team to finalize a key decision. Vanguard Security was involved in a large sale to an American

buyer, and Peter had to decide which of several foreign exchange hedging strategies was appropriate, if any. Sally

Smith, Peters bank relationship manager, and the banks chief foreign exchange advisor had provided him with

several possibilities. They were due to arrive in about an hour, giving Peter time to first meet with his team to

consider which options would be best for the company. The urgency for the meeting was due to an unanticipated

drop in currency exchange rates, which had already cost VSC a large sum of money.

Company Background and the Transaction

Vanguard Security Corporation (VSC), a European corporation headquartered in Portugal, was founded in the

early 1990s as a financial security provider for corporations with exposure to Internet fraud. Its main clients had

been major commercial banks in Europe, but now it had an opportunity to enter the U.S. market. VSC was

primarily computer software and hardware systems company with a strong reputation in the financial services

industry as one of the leading providers as well as one of the most expensive providers.

VSC had experienced rapid expansion in revenues and profits during its early growth stages. However,

increased competition from several companies in Asia had cut into its market and, as a result, revenues and profitability

had deteriorated during the past several years. Many of VSCs top managers were still with the company,

but when the company went public just prior to the bursting of the tech bubble in late 1999, several founding

owners cashed out, and new management was recruited. Subsequently, on several occasions, VSC had been forced

to cut its prices and historically high margins in order to retain customers. To remain competitive, the company

had also begun to acquire long-term debt to fund research and build production capacity by purchasing new

equipment. Because several private equity companies had been showing interest in VSC, senior management

was increasingly concerned that they might be replaced. The U.S. was viewed as a possible new market for VSC

to deploy some of its existing technology and build revenue by developing a new customer base.

Barely a week ago, Peter had been scrambling to finalize VSCs year-end income statement and balance sheet

(Figure 1). The American company, based in Boston, had insisted that Peter submit VSCs year-end financials

before allowing it to bid for the project because they wanted to make sure that if VSC won the bid, they would

have the financial resources to complete the project on time. This had delayed VSCs bid on the new project.

Figure 1. Sales and Income State

Year Ended Dec. 31	Sales Euros mil.	Net Income Euros mil.
2004	374.2	67.3
2005	401.8	88.4
2006	437.3	83.1
2007	379.9	46.3
2008	307.5	-8.7

Balance Sheet (2008)

Assets
cash and securities	2.1
accounts receviable	122.7
inventories	20.8
total current assets	145.6
properties, plant, and equipment
cost	526.8
less: accumulated depreciation	(106.0)
goodwill and intangibles	209.8
TOTAL ASSETS	776.2
liabilities
current liabilities
bank loans	122.0
accounts payable	33.4
notes payable	75.6
long term liabilities
debt	210.0
TOTAL LIABILITIES	441.0
equity and retained earnings	335.2
total liabilities and equity	776.2

The Bid

VSC had bid on a rather large project in the United States which, if accepted, could help reverse a declining net

income trend. The bid was for the design, construction, installation, testing, and provision of a six-year service

and warranty agreement. If the U.S. company accepted VSCs bid, which included a 10 percent down payment

upon acceptance, the contract specified that the first part of the project must be completed within six months.

The warranty would be paid for in equal annual installments over the life of the contract at the beginning of

each year. Most of the components of the bid would have to be built specifically to meet American standards

and be able to interface with the system currently in use by the U.S. finance company. Also, under the terms of

the agreement, VSC would have to secure a performance bond from a third-party vendor if awarded the bid.

The performance bond would cost 0.35 percent of the contract value according to Sally Smith, VSCs bank

relationship manager. Under the terms of the performance bond, the U.S. client would be paid the contract

value if VSC failed to deliver.

The bid was tendered on April 1, and on May 15, VSC was notified that they had been awarded the contract

(Figure 2). In accordance with the terms of the contract, the U.S. company had e-mailed and faxed a letter of

acceptance. The U.S. company also had notified VSC that it would be wiring 10 percent of the purchase price,

also as stipulated in the contract, on the morning of May 16.

Figure 2. Bid Preparation Euro mil.

design	3.7
materials	68.9
labor and instalation	6.9
shipping	1.2
direct overhead	3.4
allocation of indirect overhead	1.7
service and warranty agreement (6 years)	12.0
subtotal	97.8
markup (12%)	11.7
total bid in euro mil.	109.5
conversion to US $ at april 1 spot rate of US$1.4706= 1 euro
total bid in us $ mil.	US$ 161.03

The remainder of the agreed price was due at the time the system was installed, tested, and certified operational

by the American company. The target date for VSC to fulfill the terms of the contract and be paid was

November 17, six months from the day the down payment was received. The VSC chief operating officer had

verified with his suppliers that there would be no problems meeting this delivery schedule for hardware, although

the product was not currently in inventory. Similarly, the software would have to be specially developed but,

again, no problems were expected in terms of meeting the agreed-upon delivery schedule. On May 16, Peter

Levin verified that VSC had received a funds transfer of US$16.103 million. The remaining, outstanding, balance

of US$144.927 million was due on November 17, assuming all the terms and conditions of the contract

were satisfied.

In preparing the bid, VSC had allowed for a modest markup of 12 percent, which is less than what it would

have charged normally. However, VSC was concerned about its declining net income and wanted to make sure it

had a competitively priced bid, including the need to build new components. VSC knew that the quality of its

product in the European market was recognized as outstanding. But because the company was not well known

in the U.S., VSC realized that it would have to earn its outstanding brand recognition by proving it could successfully

adapt its systems to American standards.

Relationship between the U.S. Dollar and the Euro

On May 16, when VSCs bank received the wire transfer deposit of US$16.103 million, it had to be converted

into euros before VSC could begin to use the funds. Between April 1, when the bid was tendered, and May 16,

when funds were received by VSC, the euro had appreciated by about 0.74 percent relative to U.S. currency.

The exchange rate was now US$1.4815 = 1. Because of this exchange rate change between April 1 and May

15, VSC received just 10,869,389 million on May 16. This represented a loss of 80,611 due entirely to the

drop in the exchange rate, something which VSC had not anticipated. VSC now realized that it had to focus on

the value of the final payment of US$144.927 million expected on November 17. The change in the value of

the U.S. dollar relative to the euro had resulted because the U.S. Federal Reserve Board of Governors had eased

monetary policy and lowered interest rates by another 50 basis points. In contrast, the European Union had

decided not to follow this U.S. rate change and had kept its interest rates stable, thus making holding dollars less

attractive. Furthermore, in the period ahead, interest rates in Europe were expected to rise, while the opposite

was expected to happen in the United States.

Peter knew he had to act to protect the company from adverse exchange rate changes between mid-May

and mid-November but what? He had examined the movement of the US$/ exchange rate over the previous

several months before issuing the tender bid for the project, as reflected in the data in Figure 3.

Figure 3. Exchange Rates

month	End of Period /US$	End of Period US$/
april 2007	.73502	1.3605
may	.74333	1.3453
june	.74047	1.3505
july	.72955	1.3707
august	.72966	1.3705
september	.70527	1.4179
october	.69219	1.4447
november	.71401	1.4005
december	.70583	1.4168
january 2018	.69154	1.4462
february	.68593	1.4579
march	.68254	1.4652

The data reflected a significant degree of volatility, with the U.S. dollar both appreciating and depreciating

relative to the euro. He saw no reason for this pattern to change. A particularly disconcerting characteristic of

the data was that, at times, the U.S. dollar would depreciate consistently against the euro over a period of several

months. This meant that he could lose a significant share of the profit built in to his pricing of the project. He had

to find a solution because he could not afford to take this risk as his profit margin was not that large. The decision

would be made at that mornings meeting, after examining the various options and the economic outlook.

The Decision Menu: Foreign Currency Exposure Management Alternatives

The evaluation of expected macroeconomic developments in the United States and Europe confirmed Peters

concerns about a possible depreciation of the U.S. dollar relative to the euro. Indeed, the dollar had depreciated

from $1.4606 per euro to $1.4815 per euro during the time the bid was being evaluated by the U.S. client.

Further depreciation would reduce the profitability of the project for VSC. It was at this point that the banks

relationship manager for VSC arrived, accompanied by the banks chief foreign exchange risk management executive.

They explained that a foreign currency hedge would be an appropriate response to the expected foreign

exchange risk faced by VSC. Since VSC had an outstanding dollar-denominated contract, or receivable, a hedge

could be accomplished by any one of the following techniques:

1. Forward Currency Contract

A forward foreign exchange contract would involve buying a contract from the bank committing VSC to

deliver the exact amount of U.S dollars they would receive on November 17 from the American company

if they performed on their agreement with them. The forward contract, if agreed to at the meeting, would

guarantee that VSC could deliver U.S. dollars to the bank and receive euros on November 17 at todays

quoted six-month forward rate of US$1.4650 = 1.

2. Foreign Currency Futures Contract

A futures contact for euros is a standardized agreement to purchase or sell a specific amount of currency on

a specific date. A euro futures contract, usually arranged through the Chicago Mercantile Exchange in the

U.S.in this case, for 125,000could be purchased to buy or sell currency at the end of March, June,

September, and/or December. The brokers fee for the purchase was US$50.00. The buyer or seller of the

contract had to take or make delivery of the currency, and the position could only be eliminated if the futures

contract was offset. The September futures price on that spring day was US$1.4635= 1, and the December

contract price was US$1.4655 = 1.

3. Foreign Currency Options

This currency hedging instrument would give VSC the right to either purchase (call) or sell (put) a currency

at a specified price on a specific date in the future if it is a European-style option, or at anytime in the future

if it is an American-style option. The purchaser of an option has the right, but not the obligation, to exercise

the option. The purchaser can either receive the currency (call) or deliver the currency (put) if choosing

to exercise the option, or allow the option to expire unexercised. The seller, or writer, of an option, on the

other hand, must stand ready to fulfill an option obligation and surrender the currency on demand (call) or

receive the currency on demand (put).

Since VSC had a contract to be paid in U.S. dollars on November 17, it could hedge this foreign currency

exposure by buying a U.S. dollar put option or writing a U.S. dollar call option. Buying a U.S. dollar put

option would protect VSC from any unfavorable downward movement in the U.S. dollar exchange rate relative

to the euro. Writing a U.S. dollar call option would allow VSC to benefit if there was little or no change

in the exchange rate of the U.S. dollar against the euro. The purchase of a U.S dollar option would require

an option premium to be paid at the time the contract was issued. Currently, the 180-day currency option

premium on a strike price (or exercise price) of US$1.4699 = 1 was: for a call premium US$0.03256 per

unit, and for a put premium US$0.0215 per unit. If VSC wrote a call option, it would receive the premium

but might be called upon to exchange dollars for euros at a disadvantageous rate.

4. Tunnel Forwards

One alternative for VSC which would not cost the company anything up front but would give it some

exchange rate protection was a tunnel forward. This was a contractual agreement identifying a specific exchange

rate band or defined range within which VSC would have to exchange currencies on a specific future

date. The upper and lower limits of the range are like settlement rates if the actual exchange rate exceeds

the limits of the range of the tunnel. Miller, VSCs banker, indicated that such a zero cost tunnel could be

established with the strike on the euro put set at 0.7105 (US$1.4075 = 1) and the strike on the euro call

set at $0.6429 (US$1.5556 = 1).

5. Foreign Currency Loan

This product would create a US$ obligation 180 days in the future, which would be discharged by the final

dollar contract payment to VSC in November. VSC could borrow today the present value of the dollars to

be received in November. The dollars would be immediately exchanged for euros at the current spot rate,

and either be used to fund working capital needs, pay down debt, or invested in a euro financial instrument.

Thus, VSC could borrow US$ from the bank at todays meeting and convert the loan proceeds to euros to

help finance the completion of the contract. The dollars received on November 17 from completing the

contract would discharge the dollar loan, interest, and principal. Any exchange rate gains or losses on the

receivable due to a change in the value of the US$ per euro exchange rate would be offset by matching losses

or gains on the US$ per euro value of the loan.

In his role as chief foreign exchange advisor, the banker believed that a 180-day loan in U.S. dollars could

be made today at a rate of 2.0 percent above the U.S. dollar prime rate of 6.00 percent per annum plus an

arrangement fee of 0.125 percent. The comparable prime euro interest rate was 5.50 percent, with VSC

receiving a spread of 1.85 percent in the euro market for short-term investments.

6. Presale of Foreign Contract

Peter also knew that it was possible to presell the balance due on the foreign contract, or receivable, at a

discount as an alternative method of hedging exchange rate risk and raising funds to help VSC finance the

completion of the project. This alternative was different from a foreign currency loan in that it would not

add to VSCs already large outstanding debt. The discount, or interest rate, for the presale was fixed for the

180-day period at US$ LIBOR (London Inter-Bank Offered Rate), currently at 4.15 percent per annum

plus a credit risk spread for VSC of 1.8 percent. The arrangement fee for setting up this transaction was

a flat upfront fee of 0.5 percent. The current euro six-month LIBOR was 4.35 percent plus a comparable

credit spread.

Regarding the longer-term six-year service agreement, VSCs bankers recommended exploring the following

options: check if VSC had any offsetting U.S. dollar or parallel foreign currency payments (e.g., Canadian

$) to match the U.S. dollar receivable or determine if it made sense to use back-to-back or parallel loan arrangements,

or cross-currency U.S dollar-euro swap to offset the expected U.S. dollar receivable.

Current Economic Performance: Europe and United States

Economic activity was finally gaining momentum in Europe following a long period of subpar performance

while, in contrast, the U.S. economy, which had been growing at a healthy pace, was beginning to show signs

of weakness. Neither region had had serious inflation problems for some time. Unemployment continued to

be more of a problem in Europe than in the United States. However, in the period ahead, inflation and interest

rates in Europe were expected to rise, while the opposite was happening in the United States. The U.S. economic

outlook had been revised downward from earlier forecasts to about 2.5 percent, which was a slight improvement

over the previous years performance. The result would be a slight rise in unemployment and further easing in

upward pressure on prices.

The U.S. balance of payments was stabilizing following a brief period of improvement as export growth

accelerated. Meanwhile, the U.S. dollar, which had been volatile sporadically relative to the euro, was now showing

signs of depreciating, reflecting weakening confidence triggered by the subprime banking crisis, uncertainties

about U.S. policy management, and an upcoming election which would bring about a change in leadership. U.S.

monetary policy had been eased and is supportive towards restimulating growth. Earlier this year, interest rates

began to decline as the Feds policy shifted to ease credit conditions. In contrast, Europe has experienced relative

stability in money supply growth and interest rates. Even so, Europe continues to face digestion problems

politically and economicallyabsorbing all the newly entering countries into the euro zone.

Figure 4. Macroeconomic Data

	2002	2003	2004	2005	2006	2007	2008
real GDP growth US %	3.2	3.3	2.1	2.5	3.1	2.1	2.6
real GDP growth euro %	1.5	2.8	2.7	2.3	3.3	2.5	2.2
inflation CPI US %	3.4	3.2	2.6	2.6	1.9	3.4	2.3
inflation CPI euro %	2.2	2.2	1.8	2	1.8	1.9	2
unemployment US % of labor force	5.1	4.6	4.6	4.8	4.5	4.7	4.9
unemployment euro % of labor force	8.5	7.8	7.1	6.7	7.5	6.9	6.6
US gov deficit % GDP %	-3.8	-4.8	-4.6	-3.7	-2.3	-2.7	-2.6
euro gov deficit % GDP %	-2.5	-3.1	-2.8	-2.4	-1.6	-1	-0.7
US money supply growth % M2	5.6	5.3	4.1	5	6.5	6.5	6.2
euro money supply gowth % M2	6.8	6.3	8.8	8.7	9.4	9	8.5
US short term interest rate %	3.5	5.2	5.3	5	5.3	5.2	4.3
euro short term interest rates %	2.2	3.1	4.1	4.3	3.6	4.3	4.3
US long term interest rates %	4.3	4.8	4.7	4.8	4.6	4.8	4.3
euro long term interest rates %	3.4	3.8	4.2	4.3	3.8	4.2	4.3
US current account $ bil.	-459.6	-522.1	-640.2	-754.9	-811.5	-784.3	-788.3
euro current account $ bil.	47.3	42.9	109.3	27.9	0.9	-21.2	-48.8
US financial account $ bil.	463.3	520.6	637.4	740.8	808.6	758.8	735
euro financial account $ bil.	50.3	-75.7	-124.9	-50.8	1.6	35	75
US GDP $ tril.	10.5	11	11.7	12.4	13.2	14	14.7
Euro GDP EUro tril	7.3	7.4	7.7	8	8.4	8.8	9.2
euro relative to US $ daily avg.	1.061	.885	.805	.805	.797	.745	.670
US $ real effective exchange rate 2000=200	105.8	95.7	86.5	83.4	83.1	78.4	79.1
euro real effective exchange rate 2000= 100	104.66	115.35	119.93	120.45	121.72	127.87	125.2

Vanguard Security Corporation (VSC): International Transaction Dilemma

The write-up of the case should be typewritten only.

This is a real-life business case and it requires your comprehensive analysis, including basic accounting, international finance, strategic business decision-making and common business sense. Remember, this is finance class, numbers and finance logic is what is important, so ANYTHING THAT YOU SUGGEST MUST BE FINANCIALLY (numerically) SUBSTATNTIATED.

There are no wrong or right answers. I will grade your papers based on understanding of the situation, depth and quality of analysis, ability to apply what you learned in the class to a real life case, originality of thought, logical business reasoning and ability to express yourself concisely and succinctly. This is a business presentation so any belaboring the point will result in grading down.

The following is the list of questions for the case:

1. Use the relevant data provided in the case to develop the forecast for the US dollar as of April 1^st for the year ahead. Utilize your acquired knowledge of exchange rates forecasting to substantiate your numbers. Explain how what data and technique(s)you usedto arrive at this forecast?

2. Read and review the history, business model and all financial statements of the company and provide financial analysis of VSC. How strong is their financial position, and what do they need to successfully carry out the project?

3. A) Was Peters use of the spot rate on April 1st for the determination of the bid in US dollars correct? Provide a well reasoned argument for why or why not. If yes what is the best way to secure the expected revenue? If not, what should they have used for the exchange rate in the bid?

4. Based on your analysis of the bid, what is the real mark up on the bid? (Hint: this has nothing to do with the exchange rate, but everything to do with the cost accounting!)

5. Analyze each of the available hedging alternatives financially and strategically. Make your recommendation for either hedging or not, and, if hedging, recommend the best hedging alternative. Base your recommendation on the financial analysis of various alternatives in the case, financial analysis of the company, and projection of exchange rates.