Blades plc Case Study

As the chief financial officer of Blades plc Ben Holt is pleased that his current system of exporting Speedos to Thailand seems to be working well. Blades primary customer in Thailand, a retailer called Entertainment Products, has committed itself to purchasing a fixed number of Speedos annually for the next 3 years at a fixed price denominated in baht, Thailands currency. Furthermore, Blades is using a Thai supplier for some of the components needed to manufacture Speedos. Nevertheless, Holt is concerned about recent developments in Asia. Foreign investors from various countries had invested heavily in Thailand to take advantage of the high interest rates there. As a result of the weak economy in Thailand, however, many foreign investors have lost confidence in Thailand and have withdrawn their funds. Ben Holt has two major concerns regarding these developments. First, he is wondering how these changes in Thailands economy could affect the value of the Thai baht and, consequently, Blades. More specifically, he is wondering whether the effects on the Thai baht may affect Blades even though its primary Thai customer is committed to Blades over the next 3 years. Second, Holt believes that Blades may be able to speculate on the anticipated movement of the baht, but he is uncertain about the procedure needed to accomplish this. To facilitate Holts understanding of exchange rate speculation, he has asked you, Blades financial analyst, to provide him with detailed illustrations of two scenarios. In the first, the baht would move from a current level of $0.022 to $0.020 within the next 30 days. Under the second scenario, the baht would move from its current level to $0.025 within the next 30 days. Based on Holts needs, he has provided you with the following list of questions to be answered:

1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the Thai bahts value from a value of $0.022 to $0.026.

2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors?

3. How might the relatively high levels of inflation and interest rates in Thailand have affected the bahts value? (Assume a constant level of US inflation and interest rates.)

4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, affected the bahts value? Would Blades be affected by the change in value, given the primary Thai customers commitment? 5. Assume that Thailands central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currencys value. How could it accomplish this objective using interest rates? 6. Construct a spreadsheet illustrating the steps Blades treasurer would need to follow in order to speculate on expected movements in the bahts value over the next 30 days. Also show the speculative profit (in Dollars) resulting from each scenario. Use both of Ben Holts examples to illustrate possible speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount. Furthermore, assume that the following short-term interest rates (annualized) are available to Blades: Currency

Currency

Lending Rate

Borrowing Rate 8.20% 15.40%

Dollars Thai baht

8.10% 14.80%

Solution to Continuing Case Problem: Blades. 1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the Thai bahts value from a value of $0.022 to $0.026.

ANSWER: The percentage change in a currencys value is measured as follows: % = Ask Bid Bid A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation.

$0.026 - $0.022 = 18.18% $0.022 That is, the baht would be expected to appreciate by 18.18%.

2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors?

ANSWER:

The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. From the theory of supply, high level of supply of a currency that can decreases the currencys value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency.

3. How might the relatively high levels of inflation and interest rates have affected the bahts value? (Assume a constant level of US inflation and interest rates.)

ANSWER:

The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the US. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for US goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the US demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for US investors, causing an increase in the demand for baht. Furthermore, US securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailands inflation.

4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, affected the bahts value? Would Blades be affected by the change in value, given the primary Thai customers commitment?

ANSWER: In general, depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency for sale. Blades would probably be affected by the change in value even though its Thai customers commitment, the sales are denominated in baht. Thus, the depreciation in the baht would have caused a conversion of the baht revenue into fewer dollars.

5. Assume that Thailands central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currencys value. How could it accomplish this objective using interest rates?

ANSWER: If Thailands central bank wishes to prevent further depreciation in the bahts value, it would attempt to increase the level of interest rates in Thailand. In turn, this would increase the demand for Thai baht by US investors, as Thai securities would now seem more attractive. This would place upward pressure on the currencys value. However, the high interest rates could reduce local borrowing and spending. 6. Construct a spreadsheet illustrating the steps Blades treasurer would need to follow in order to speculate on expected movements in the bahts value over the next 30 days. Also show the speculative profit (in dollars) resulting from each scenario. Use both of Ben Holts examples to illustrate possible speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount. Furthermore, assume that the following short-term interest rates (annualized) are available to Blades:

Currency Dollars Thai baht

Lending Rate 8.10% 14.80%

Borrowing Rate 8.20% 15.40%

ANSWER: u Depreciation of the Baht from $0.022 to $0.020

No. Scenario 1 1 2 3 Borrow Dollars Convert the Dollars to Thai baht ($10,000,000/$0.022) Lend the Thai Baht at 14.80% annualized, [computed as 14.80% (1/12)]. After 30 days, Blades would receive (THB 454,545,454.5 (1 + 0.0123)) 4 Number of Baht necessary to repay Dollars loan (THB 460,136,363.6 $0.020) 5 Use the proceeds of the dollar loan repayment (on Day 30) to repay the US dollar borrowed. The annual interest on the Dollars borrowed is 8.20%, or 0.68% over the 30-day period [computed as 8.20% (1/12)]. The total US Dollars amount to repay the loan is (10,000,000 (1 + 0.0068)) 6 7 Speculative profit ($9202727.272 - $ 10,068,000) Baht equivalent of speculative profit ($ 865,272.278/0.020)

Currency $/THB $10,000,000 THB 454,545,454.5 THB 460,136,363.6

$ 9,202,727.272

($ 10,068,000)

($ 865,272.278) (THB 43263613.9)

Appreciation of the Baht from $0.022 to $0.025

No. Scenario 2 1 2 3 Borrow Dollars Convert the dollars to Thai baht ($10 million/$0.022). Lend the baht at 14.80% annualized, which represents a 1.23% return over the 30-day period [computed as 14.80% (1/12)]. After 30 days, Blades would receive (THB 454,545,454.5 (1 + 0.0123)) 4 Number of baht necessary to repay dollar loan (THB 460,136,363.6 $0.025) 5 Use the proceeds of the baht loan repayment (on Day 30) to repay the dollars borrowed. The annual interest on the dollars borrowed is 8.20%, or 0.68% over the 30-day period [computed as 8.20% (1/12)]. The total dollar amount necessary to repay the loan is ($10,000,000 (1 + 0.0068)) 6 7 Speculative profit ($ 11,503,409.09 $ 10,068,000) Baht equivalent of speculative profit ($1,435,409.09/0.025)

Currency $/THB $10,000,000 THB 454,545,454.5 THB 460,136,363.6

$11,503,409.09

($10,068,000)

$1,435,409.09 THB 57,416,363.6

Blades would be ill advised to speculate in this way as it is not a specialist in the financial markets and does not have specialist abilities or information to use. These actions can be little better than gambling and are highly ill advised.