When in Doubt, Hedge!

It was a hot, humid afternoon in April. Kirk could feel the pressure mounting. The memo on his desk read, Please see me immediately! Kirk knew that, sooner or later, his boss, Brian Daltrey, was going to ask him to implement some quick remedies to improve the profit situation. The quarterly financial statements had just been published and for the fourth quarter in a row, The Pre-Fab Pipe Corporation had reported a sharp drop in earnings per share despite a consistent increase in revenues. Needless to say, the shareholders were irate and the public relations department had been inundated with calls from concerned shareholders wondering what was going on. In fact, at the annual meeting held last quarter, the firms shrinking profits were the main topic of discussion. It led to the early retirement of the Chief Financial Officer, Mitch Graves.

The Pre-Fab Pipe Corporation, headquartered in Delaware, had established manufacturing facilities in Illinois, California, Ohio, and Pennsylvania. It specialized in the manufacture of high-grade copper piping of various thicknesses and circular dimensions. The pipes were used primarily in commercial and residential applications. 70% of its sales were accounted for by exports to the United Kingdom while the rest came from sales to wholesalers in the United States.

Over the past year, copper prices had fluctuated significantly (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 ($2.62/lb.). That was the price that had been figured into the cost structure. Unfortunately, due to the stiff competition that characterized the piping industry, Pre-Fab was unable to shift the price increases on to the wholesalers. To make matters worse, the U.S. dollar had strengthened significantly over the prior 12 months resulting in further loss of profits upon conversion of British pounds into dollars. The dollar had gone from $1.55 per British pound, 12 months ago, to its current level of $1.42 per British pound. Due to the fierce competition in the overseas market, British wholesalers were able to negotiate very favorable terms including 90 days credit and payment in British pounds.

Part of the problem at Pre-Fab was that the previous CFO, Mitch Graves, had not been very familiar with the mechanics of the derivatives market. He had, therefore, not hedged the companys commodity and exchange rate exposures at all. Upon Mitchs retirement, Brian Daltrey, was appointed as the CFO. Brians first move was to recruit Kirk Sheehan, a derivatives expert. Kirk had earned an MBA in Finance at a major mid-western university and had worked for five years at the Chicago Mercantile Exchange, prior to joining Pre-Fab. The company had made him an offer that was too good to resist and Kirk knew that sooner or later the pressure would be on to prove his worth.

In preparation for the meeting with Brian, Kirk gathered information from the purchasing, sales, payables, and receivables departments. The sales department had booked orders for $130 million worth of pipes, 70% of which was from British clients. Kirk estimated that the company would need about 40 million pounds worth of high-grade copper by the end of three months to manufacture the pipes. Copper was being quoted at $2.72 per pound in the spot market and the British pound was quoted at $1.42 per pound. There was a likelihood that copper prices could go down and the dollar could weaken against the British pound, but the reverse could also happen. Kirk knew all too well that the market could go either way and remembered vividly what his prior boss used to often say, When in doubt, hedge! He feared that if copper prices were to appreciate along with the dollar, corporate profits would be significantly affected and he would be out looking for a job. He liked this company a lot and the lavish compensation package he had been offered was definitely worth keeping. I had better come up with some effective hedging combinations, thought Kirk. This is no time to take a wait and see approach.

Kirk tapped on his laptop and checked the Internet for the latest quotes on futures contracts trading on the British pound and on high-grade copper (see Tables 25). After jotting down some numbers and making some quick calculations, Kirk picked up the phone. Brian, he said with a smile on his face, About that meeting you wanted to have with meCan we meet right away?

Table 1 Historical Spot Prices of High-Grade Copper

Month End		Price (cents/lb.)
May	2014	262.00
June	2014	264.75
July	2014	266.25
August	2014	265.70
September	2014	267.30
October	2014	264.45
November	2014	261.80
December	2014	270.40
January	2015	271.50
February	2015	273.35
March	2015	274.50
April	2015	272.00

Table 2 British Pound Futures Contract Specifications

Trading Unit:	62500 British pounds
Price Quotation:	U. S.$ per pound
Trading Symbol:	BP
Initial Margin:	$1080 per contract
Maintenance Margin:	$800 per contract

Table 3 British Pound Futures Settlement Prices as of April 2015

	Daily			EST			Prior Day			Open
Mth/Strike	Open	High	Low	Last	Sett	Chge	Vol.	Sett	Vol.	Int.
JUN15	1.4324	1.4332	1.4296	1.4312	1.4314	20	1792	1.4334	7901	35237
SEP15	1.4230	1.4256	1.4228	1.4250	1.4234	20	1	1.4254	31	880
TOTAL							1793		7932	36117

Table 4

Copper Futures Contract Specifications

Trading Unit:	25000 lbs.
Price Quotation:	cents per lb. For example, 273.80 cents per lb.
Trading Symbol:	HG
Initial Margin:	$1350 per contract
Maintenance Margin:	$1000 per contract

Table 5

Copper Futures Settlement Prices as of April 2015

Contract	Expiration Date	Todays Settle	Previous Settle	Volume	Daily High	Daily Low
HG 04 15	4/26/2015	271.5	272.1	64	271.6	270.2
HG 05 15	5/29/2015	271.7	272.3	7,039	272.4	271.2
HG 06 15	6/26/2015	272.05	272.65	58	272.15	271.95
HG 07 15	7/29/2015	272.4	270	1,942	273	271.9
HG08 15	8/28/2015	272.7	273.3	10	273.1	272.5
HG 09 15	9/26/2015	272.95	273.5	125	273.45	272.75
HG 10 15	10/29/2015	273.2	273.7	3	273.25	273.25
HG 11 15	11/25/2015	273.45	273.95	2	0	0
HG 12 15	12/27/2015	273.7	274.2	234	274.25	273.3

QUESTIONS ( PLEASE ANSWER AND HELP WITH ALL OF THEM)

1) Brian questions Kirk, What about forward contracts? Why not use forward contracts instead? How should Kirk respond?

2) During their meeting, Brian told Kirk that the firm had been forced to use floating-rate loans for expansion due to their low credit rating. Although long-term rates were higher, the firm would have preferred to match the maturity of the debt with the duration of their financing need. Besides, short-term rates had been rising and were expected to continue going up due to rising inflation. The firm currently had borrowed $2 million at a floating rate of prime plus 1% (currently 6.5%). Longer-term, fixed rate debt was available at 9% per year. Brian had heard about interest rate swaps and asked Kirk to explain to him how Pre-Fab could use a swap to minimize their interest rate risk. How should Kirk respond?

3) Besides an interest rate swap, what strategies could Kirk recommend to Brian to help minimize the companys exposure to interest rate risk?