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Individual Assignment

Financial Management

Professor Gordon Roberts

Forex Hedging for Advance Technologies Inc.

      by

Edward He

Kellogg-Schulich EMBA Class KS09

Student No. 210694719

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TABLE OF CONTENTS

1.0 BACKGROUND 3

2.0 SENSITIVITY ANALYSIS ON CASH FLOW AND NET INCOME 4

3.0 COSTS AND BENEFITS OF HEDGING STRATEGIES 5

4.0 PROS AND CONS OF COLLAR 8

5.0 ALTERNATIVE DERIVATIVES STRATEGIES 10

6.0 ALTERNATIVE CURRENCY STRATEGY (NON DERIVATIVE HEDGING) 12

7.0 RECOMMENDATION 13

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1.0 BACKGROUND

1.1 COMPANY PROFILE

Advance Technologies Inc. (“Advance”) is a manufacturer of a wide range of engineered plastic products

in Canada. The company’s value proposition is to pursue a strategy focused on specialty, proprietary

products, which affords Advance a lasting competitive advantage. In order to pursue this strategy,

Advance entered into a licensing agreement with Hart Industries, a large plastic resin manufacturer based

in New York, on September 30, 1991. The agreement granted Advance exclusive Canadian

manufacturing and distribution rights to a revolutionary new plastic, Cryolac.

1.2 FOREIGN EXCHANGE EXPOSURE

Advance is exposed to significant foreign exchange risk as a result of Hart agreement. While all of the

company’s revenues are denominated in Canadian dollars, a large part of its expenses are paid in U.S.

dollar. Consequently Advance had to regularly convert its Canadian dollar cash flows to cover expenses

in the U.S. As the Canadian dollar weakened, Advance’s cash flow and profitability are adversely

affected.

As indicated in its Pro forma Income Statements as of fiscal September 30, 1993, Advance expects to

report revenue of C$160 million, while expenses in U.S. dollar totaled US$40.598 million (equiv.

C$49,509 million). Major expenses incurred in U.S. funds include 1) raw material import from Hart

Industries, 2) a US$250,000 monthly licensing fee payable to Hart, and 3) interest payments on Hart’s

vendor take back loan (US$1 million), full principal repayment due on September 30, 2001.

It is obvious that Advance generates its sales in Canada, while 33.6% ($49.5M out of $147.5M) of its

expenses are in U.S. currency, therefore there is a mismatch of the company’s currency cash flow

structure and it is susceptive to foreign exchange risks, i.e. negative impact from the volatility of the

CAD/USD exchange rates.

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1.3 CONCERNS OVER CASHFLOW AND LOAN COVENANTS

In closing the licensing agreement with Hart Industries, cost associated with the upfront investment in

Cryolac, and the purchase of specialty manufacturing equipment were mostly financed by loan from a

Canadian bank, coupled with a US$1 million vendor note from Hart Industries, which was payable in full

ten years from the date of the agreement. Contained in the Canadian loan agreement were several

covenants regarding profitability, including a minimum before tax profit condition of $9 million.

Currency exchange rate fluctuation would make major impact on Advance’s Income Statement, as 33.6%

of the expenses are denominated in USD. This will directly affect Advance’s cash flow, EBITDA and net

income, which may trigger an event of default under the loan agreement if before tax earning falls below

the $9 million covenant.

2.0 SENSITIVITY ANALYSIS ON CASHFLOW AND NET INCOME

A Sensitivity Analysis of cash flow and net income without forex hedging is conducted based on a range

of forecasted Canadian/U.S. dollar exchange rates provided by management.

Revenue 160,000CAD cash expense 88,358USD cash expense (CAD equivalent) 49,509Depreciation 9,640EBT 12,493Tax (40%) 4,997Net Income 7,496

Cash flow ReconcilationDepreciation 9,640Free Cash Flow (net income + depre.) 17,136

Note:  1. Exchange rate is @1.2195 CAD/USD 2. Cash flow calculation excludes changes in Working Capital and Capital Expenditure.

Pro forma Income Statements as of September 30, 1993

With above methodology, we have sensitized Advance’s EBT (Earning before tax), Net Income and Free

Cash Flow as of Sep 30, 1993 based on 4 projected exchange rates of Canadian dollar at 1.2395, 1.2595,

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1.2795 and 1.2995 as follows (in above calculation, only Canadian dollar equivalent of U.S. expense

varies in accordance with different exchange rates),

CAD/USD exchange rate Free Cash Flow EBT Net Income1.2195 17,136 12,493 7,4961.2395 16,649 11,681 7,0091.2595 16,161 10,869 6,5211.2795 15,674 10,057 6,0341.2995 15,187 9,245 5,547

Foreign Exchange Sensitivity Analysis

Given Advance imports a large component of raw material, the depreciation of Canadian dollar against

U.S. dollar has adverse effect on the company’s cash flow and net income. As revealed by the sensitivity

analysis, a 6.6% depreciation of Canadian dollar (from 1.2195 CAD/USD in Base Case to 1.2995

CAD/USD of Worst Case) would reduce free cash flow by 11.4% (from $17,136K to $15,187K), EBT by

26% (from $12,493K to $9,245K), and net income by 26% (from $7,496K to $5,547K). Notwithstanding,

Advance’s EBT is projected at $9.245 million in the worst case scenario, which still affords the company

to meet its loan covenant. This indicates Advance’s strong profitability and earning momentum.

3.0 COSTS AND BENEFITS OF HEDGING STRATEGIES

According to Pro forma Income Statements as of September 30, 1993 prepared by management,

Advance’s annual spending in U.S. dollar is US$40,598K (=C$49,509K/1.2195) and cash flow

requirement are relatively stable throughout the course of the year. Consequently, we assume Advance’s

monthly U.S. funds requirement is US$3,383K (=US$40,598K/12).

3.1 HEDGING WITH AT-THE-MONEY CALL OPTIONS

With at-the-money call options, Advance would hedge its FEX exposure by purchasing 12 call options

(with strike price at current spot rate, i.e. @1.2536) in amounts equal to the anticipated monthly U.S.

dollar cash outflow with expiry in each month over the next 12 months. The result of this strategy is to set

a lower limit/floor to the cost of future purchase of U.S. dollar at current spot rate.

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Costs: The 12 option contracts long position will cost Advance $1.035 million for the option premium.

C$1,035K (=USD40,598K x 1.2536 x 2.034%). 2.034% is the average call premium rate of the 12 call

options. Under this strategy, maximum exchange rate Advance will pay for purchase of USD is 1.2536,

will equate to C$50,894K.

Strike Price = 1.2536 40,598                                                     USD 000'sExpiry Date 1.2536 Tenure Call Premium Rate Premium

October‐31‐92 4,241.14                                                  1‐month 1.25% 53.01       November‐30‐92 4,241.14                                                  2‐month 1.52% 64.47       December‐31‐92 4,241.14                                                  3‐month 1.74% 73.80       

January‐31‐93 4,241.14                                                  4‐month 1.82% 77.19       February‐28‐93 4,241.14                                                  5‐month 1.90% 80.58       

March‐31‐93 4,241.14                                                  6‐month 1.99% 84.40       April‐30‐93 4,241.14                                                  7‐month 2.09% 88.64       May‐31‐93 4,241.14                                                  8‐month 2.20% 93.31       June‐30‐93 4,241.14                                                  9‐month 2.31% 97.97       July‐31‐93 4,241.14                                                  10‐month 2.42% 102.64     

August‐31‐93 4,241.14                                                  11‐month 2.53% 107.30     September‐30‐93 4,241.14                                                  12‐month 2.64% 111.97     

Average 2.034%Total 50,893.65                                               1,035.26 

Hedging with at‐the‐money Call Options

Benefits: At-the-money call options strategy provides Advance a ceiling (protection) of future FX rate at

1.2536 CAD/USD. If USD appreciates against CAD, Advance would exercise the options and settle USD

purchase at strike price. On the other side, this strategy also provides Advance with upside potential to

participate. In the event that USD depreciates, Advance would leave these options expire worthless, and

simply purchases USD at current spot market to take advantage of lower USD exchange rate.

Maximum loss: C$1.035 million option premium cost if spot price upon maturity is lower than exercise

price.

Advantage: 1) Option contract gives the owner/buyer the right, but not the obligation, to buy or sell USD

at a specified price for a specified time. 2) Option buyer would participate upside potential, while being

protected at ceiling, i.e. maximum is the strike price. 3) Currency options are traded on exchange.

Payments are guaranteed by clearing house, which essentially eliminates credit/counterpart risk.

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Disadvantage: 1) Upfront cost to pay for the option premium. 2) Options are standard contracts traded on

exchanges with standard contract amounts and expiration dates. This makes perfect hedging impossible

(inability to customize amount and/or maturity).

3.2 HEDGING WITH FORWARD CONTRACTS

With currency forward contracts, Advance would purchase 12 forward contracts with terms expire each

every month over the next 12 month. This effectively locks in Advance FX rate at average @1.2719.

Strike Price = 1.2536 40,598                            USD 000'sExpiry Date 1.2536 Tenure Forward Rate (Offer) CAD/USD

October‐31‐92 4,262.11                        1‐month 1.2598November‐30‐92 4,275.98                        2‐month 1.2639December‐31‐92 4,291.89                        3‐month 1.2686

January‐31‐93 4,294.93                        4‐month 1.2695February‐28‐93 4,298.65                        5‐month 1.2706

March‐31‐93 4,302.71                        6‐month 1.2718April‐30‐93 4,308.80                        7‐month 1.2736May‐31‐93 4,313.54                        8‐month 1.2750June‐30‐93 4,318.61                        9‐month 1.2765July‐31‐93 4,322.00                        10‐month 1.2775

August‐31‐93 4,325.04                        11‐month 1.2784September‐30‐93 4,328.42                        12‐month 1.2794

Average 1.2719Total in CAD 51,642.69                      Margin @8% 4,131.41                                             

Hedging with Forwards Contracts

Costs: No money change hands when the contract is initiated, so there is no upfront cost. Nevertheless,

Advance is required by FX Dealer to post margin/collateral equal to 8% of the face amount of the forward

contracts notional amounts. C$4,131K (=C$51,637 x 8%). Under this strategy, Advance would spend

C$51,637K (=US$40,598K x 1.2719) to purchase the required USD.

Benefits: Hedging with forward contract does eliminate the risk associated with an adverse price change.

Maximum loss: None, however the CAD/USD exchange rates have been fixed for the next 12 months.

Advantage: 1) No upfront cost to initiate forward contracts position. 2) Eliminate foreign exchange risk

by fixing the rates. 3) Over the Counter transaction, could be customized for amounts, maturities.

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Disadvantage: 1) Forwards eliminates the FX risk, however, not like options, it also eliminates future

potential gain as forwards must be settled upon maturity regardless of market conditions. 2) Because a

forward contract is a financial obligation, there is credit/counterpart risk. It is transacted OTC, no clearing

house or exchanges guarantee payments. 3) To reduce counterpart risk, FX Dealer requires posting

margin/collateral (in our case, it is equal to 8% of the face amount of the contract notional amount,

totaling C$4.071 million). This margin may take the form of a guaranteed line of credit at the Bank. We

note Advance projects only C$678K cash balance by Sep 30, 1993, if a FX credit line is not available,

Advance would be forced to borrow cash from the Bank to put up margin with FX Dealer. This would

elevate Advance’s debt level and interest expense. Nevertheless, we acknowledge in real world,

margin/collateral requirement varies depending on forwards maturity, and respective mark-to-market

gains/losses. 4) Settlement is mandatory; however Advance could purchase offsetting forwards to unwind

its positions.

4.0 PROS AND CONS OF COLLAR

4.1 AT-THE-MONEY COLLAR

With at-the-money collar, Advance essentially locks in its FX rate at strike @1.2536, which is also the

current foreign exchange spot rate. Under this strategy, if CAD/USD exchange rate goes up, the call

option is in the money and Advance would exercise the call option, and let the put option expire worthless.

On the flip side, if rate goes down below 1.2536, the put option buyer would exercise and force Advance

to sell USD at 1.2536 (Advance would have to purchase USD from the spot market at a lower rate first)

and the call option would expire worthless.

Advantages: Much lower upfront option premium. Average 12.6 basis points versus 203.4 basis points

for call only strategy. As per at-the-money call options table, average call premium is 2.034% and

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average put premium is 1.908%. Premium spread is 0.126% (=2.034% - 1.908%). Overall premium cost

is C$64K (=C$50,894K x 0.126%) versus C$1,035K for call only strategy.

Disadvantages: 1) The at-the-money collar fixes Advance’s FX rate at 1.2536, a feature similar to

forward contracts, while call only strategy can participate upside potential. Call options only protects

Advance from unfavorable appreciation of USD against CAD, but also affords Advance benefit should

USD depreciate. 2) A 4% margin/collateral is required by Dealer for the put options Advance writes.

C$2.065 million (=C$51,637K x 4%).

4.2 ZERO-COST COLLAR

With zero-cost collar, the strike price of each contract would be set in such a way that the cost of the call

premium would be just offset by revenue from the sale of the put. Therefore zero cost collars do not

require upfront cost, and the strategy effectively locks Advance’s future FX rate in a prescribed range,

zero cost tunnels.

 

1.22

1.23

1.24

1.25

1.26

1.27

1.28

1.29

1.3

Puts

Calls

 

If CAD/USD exchange rate moves above the upper bound/ceiling (call strike price), the call option is in

the money and Advance would exercise the call and put option will be out of money. If USD declines in

value below the lower bound/floor (put strike price), which is in Advance’s favor, the put option will be

exercised against Advance. The result is that the rate Advance pays will not drop below the floor rate.

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Advantages: There is no net cash outlay required to create the position, it is zero cost.

Disadvantages: 1) The rates Advance pays will always be between the floor and the ceiling, while a call

option only strategy affords Advance the upside potential should USD depreciate. 2) Advance may have

to post a 4% margin/collateral for the put options it sells. C$2.036 million (=C$50,894K x 4%).

5.0 ALTERNATIVE DERIVATIVES STRATEGIES

In addition to currency option and forwards, Advance could also employ a number of alternative

derivatives in its hedging program.

5.1 CURRENCY FUTURES

Advance could purchase U.S. currency futures through futures exchanges. A future contract is exactly the

same as a forward contract, however with a forward contract, the buyer and seller realize gains and losses

only on the settlement date. With a futures contract, gains and losses are realized on a daily basis, i.e.

mark-to-market. Hedging with futures contracts is conceptually identical to hedging with forward

contracts, and the payoff profile on a futures contract is just like the profile of a forward contract. The

only difference in hedging with futures is that Advance will have to maintain an account with an

investment dealer so that gains and losses can be credited or debited each day as a part of the mark-to-

market process.

Pros: No credit/counterpart risk. Futures contracts are traded on exchange, which requires daily

settlement of mark-to-market. Default risk on counterparts is greatly reduced.

Cons: 1) Gain/loss is realized on daily basis due to mark-to-market, while with forward contracts,

gain/loss is realized only on settlement date. 2) Futures are unlikely to take delivery, the position would

be eliminated by taking an offsetting position before expiration. 3) Futures are exchange traded contracts,

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which have standard maturity date for each month and contract amount, while forwards are OTC products

and can be customized with the FX dealer.

5.2 CURRENCY SWAPS

A swap contract is a series of forward contracts. Advance could purchase currency swaps, with a Swap

Dealer, to exchange a specific amount of USD for CAD at specific dates in the future. A swap contract is

just a portfolio or series of forward contracts, i.e. there are multiple exchanges instead of just one.

Pros: 1) Comparing with forwards, instead of entering 12 individual forward contracts with maturities in

each month, Advance could enter into one tailored currency swap to exchange USD for CAD each month

for the next 12 months. 2) Eliminate FX volatility risk by locking in currency conversion rates.

Cons: 1) Credit risk given swap is an OTC transaction. 2) Like forwards, it does not afford upside

potential.

5.3 FUTURES OPTIONS

Advance could also purchase futures options on USD. When a futures call option on USD is exercised,

Advance receives two things. The first is a futures contract on USD at the current futures price. This

contract can be immediately closed at no cost. The second thing Advance receives is the difference

between the strike price on the option and the current futures price. The difference is paid in cash.

Pros: 1) No credit/counterpart risk, futures options are traded on exchange. 2) Like option, futures

options afford Advance upside potential.

Cons: 1) Upfront cost to pay for option premium. 2) Standard exchange traded contracts, can’t be

customized.

5.4 SWAPTIONS

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Advance could also purchase currency swaptions, an option to allow the buyer to enter swap at prescribed

prices.

Pros: 1) The option will allow Advance to participate upside potential. 2) If the swaption is exercised,

Advance will be entitled to enter swap contract with Dealer. Comparing with forwards, instead of

entering 12 individual forward contracts with maturities in each month, Advance could enter into one

tailored currency swap to exchange USD for CAD each month for the next 12 months. 2) If swap is

entered, this would eliminate FX volatility risk by locking in currency conversion rates.

Cons: 1) Credit risk given swaption is an OTC transaction. 2) Once swaption is exercised, the buyer

enters into a swap, where upside potential is eliminated.

6.0 ALTERNATIVE CURRENCY STRATEGIES (NON DERIVATIVE HEDGING)

Alternative currency strategies are surrounding creating natural currency hedge for Advance.

Generate revenue outside of Canada. The best hedging strategy is natural hedge. Advance could tap

into the U.S. and/or international markets for its innovative products, to generate revenue in U.S.

dollar. Advantage: 1) Increase overall sales. 2) Revenue diversification by geography. 3)

Effectively reduce forex risk, i.e. revenue in U.S. dollar would be used to pay for USD expense.

Disadvantage: 1) Marketing in U.S. and/or international markets could be challenging for a

Canadian firm like Advance, which only sells domestically at present. 2) Advance would require

new licensing agreement for new markets. 3) Incur additional start-up cost. 4) If Canadian dollar

appreciates in value against US dollar going forward, Advance may lose its cost competitive

advantage as a Canadian based manufacturer. 5) Perfect hedge is impossible as revenue in USD

wouldn’t perfectly match USD expense.

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Convert USD expense into CAD. Pass FX risk on to vendor. Advance could re-negotiate with Hart

Industries to purchase Cryolac raw material and pay licensing fee in Canadian dollar next year.

Advantage: Eliminate forex exposure and risk. Disadvantage: Difficult to implement unless

Advance has superior bargaining power over Hart Industries.

Risk sharing with vendor. Advance could re-negotiate with Hart Industries to set the transfer

pricing as a 12 month moving average of CAD/USD rates. Advantage: Partially reduce forex

exposure by risk sharing with vendor. Disadvantage: Difficult to negotiate.

Generate domestic sales in USD. Another option would be for Advance to amend sales term with

some of customers to request payments in USD instead of CAD. Advantage: Could effectively

eliminate forex risk. Disadvantage: Difficult to negotiate. While Cryolac was a premium product it

faced competition from Canadian produced plastics. Advance may risk losing its clients if it forces

them to pay USD.

7.0 RECOMMENDATION

Based on our analysis, we would recommend Advance to employ at-the-money option collar strategy.

Cost comparison is as follows,

7.1 FORWARD IS INFERIOR TO AT-THE-MONEY COLLAR

Although no upfront cost incurred to establish the 12 forwards positions, Advance would have to pay an

average of 1.2719 CAD/USD to purchase USD over the period of time, translating C$51,637K

(=US$40,598K x 1.2719) in total cost.

With the at-the-money collar, Advance effectively locks in its exchange rate at 1.2536 for the next 12

months, while only pays a nominal premium of $64K (=C$50,894 x 0.126%). This strategy costs

Advance total C$50,958K (=US$40,598 x 1.2536 plus C$64K premium) to purchase the required U.S.

funds.

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In terms of margin/collateral condition, collar requires a 4% margin on the put options, while forwards

require 8% margin.

7.2 ZERO-COST COLLAR IS INFERIOR TO AT-THE-MONEY COLLAR

Expiry Date Puts CallsOctober‐31‐92 1.2491 1.2690

November‐30‐92 1.2508 1.2749December‐31‐92 1.2541 1.2799

January‐31‐93 1.2541 1.2821February‐28‐93 1.2542 1.2842

March‐31‐93 1.2542 1.2863April‐30‐93 1.2553 1.2880May‐31‐93 1.2564 1.2897June‐30‐93 1.2575 1.2915July‐31‐93 1.258 1.2927

August‐31‐93 1.2585 1.2938September‐30‐93 1.259 1.2950

Average 1.2551 1.2856

Zero‐cost Collar

As depicts in above table, zero-cost collar establishes a band/tunnel rates for Advance over the next 12

months, with average upper bound at 1.2856 and lower bound at 1.2551. Given the lower bound of

1.2551 (the lowest Advance would have to pay) is even higher than the strike price of 1.2536 for at-the-

money collar. It is obvious that at-the-money collar is superior to zero-cost collar, the only adds-on cost

for at-the-money collar is the $64K net premium. Both strategies require a 4% margin posted for put

options.

7.3 DEBATE BETWEEN CALL OPTION ONLY AND AT-THE-MONEY COLLAR

While at-the-money collar locks in Advance’s USD purchase cost at 1.2536, the call option only strategy

establishes a ceiling exchange rate at 1.2536 for Advance in the worst case scenario, and also affords

Advance to participate upside potential in case USD depreciates in value against CAD. This benefit

comes up with a cost, 1.908% or C$971K i.e. spread between the premiums of the two strategies or the

put premium that Call Only does not have to pay.

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In breakeven analysis, the CAD/USD rate has to drop to 1.2297 to make the two strategies indifferent,

1.2297 = (C$50,894K-C$971K)/US$40,598, i.e. the cost savings on call option only to fully offset the

additional premium incurred.

By observing the FX forwards quotes in Exhibit 6 provided by forex dealer, the future CAD/USD curve is

contango, i.e. USD expects to appreciate over the next 12 months. This is largely stimulated by the

uncertain Canadian political environment, that an upcoming Canadian Constitutional Referendum on

whether Quebec can secede from the rest of Canada. This negative headline news has already taken its

toll on Canadian dollars, which has fallen 3.56 cents in value relative to the U.S. dollar since the first of

September. Some currency analyst forecast Canadian dollar could lose another 1.5 cents in value by the

time of the referendum with no end to the market turmoil in sight, according to Global and Mail as at Sep

22/92.

Given the market forecast and consensus that the Canadian dollar will continue to depreciate against U.S.

dollar in at least short run, the $971K additional premium call option has to carry add little value as

upside potential is unlikely. We therefore recommend at-the-money collar strategy, which provides the

lowest overall cost for Advance to hedge its foreign exchange in its current market environment.