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Currency Risk Exposure

DERIVATIVE INVESTMENT

CASE STUDY ANALYSIS


On
"Case 31: Merton Electronics Corporation"

Instructor
Sir Akbar Khan

Group Members
Syed Aamir Abbas
Asif Riaz
Faisal Ayub

BBA-VIII (ABC)

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Currency Risk Exposure

Table of Contents

2....................................................................................................................Introduction
4..............................................................................................................SWOT Analysis
4................................................................................................................... Strengths:
5.............................................................................................................. Weaknesses:
7.............................................................................................................Opportunities:
8.......................................................................................................................Threats:
9..........................................................................................................................Findings
11.................................................................................Company's Transaction Analysis
16.............................................................................................................Implementation
16....................................Foreign Currency Risk: Minimizing Transaction Exposure
16.................................................................................The Foreign Exchange Market
17..................................Non-Hedging Techniques to Minimize Transactions Exposure
17.............................................................Reducing Short-Term Foreign Currency Risk
17....................................................................................................Forward Contracts
18......................................................................................................Futures Contracts
18.............................................................................Hedges Using the Money Market
18.....................................................................................................................Options
19..........................................................................................................Cross Hedging
19.........................................................Mitigating Long-Term Currency Risk Exposure
19.................................................................................................Back-to-Back Loans
19.................................................................................Currency Swaps/Credit Swaps
20........................................................................................................Recommendations
22....................................................................................................................Conclusion
23....................................................................................................................References

Introduction
We have study the whole case which is "Merton Electronics Corporation", then by
using secondary resources on internet like by studying articles, journals, related
web pages, research papers, term papers and different case study write-ups,
then we have explore more information on this whole case, then we have discuss

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main problems and issues of the companies with each other deeply and then
finally we are able to write the case study analysis with collective effort.

Patricia Merton had been working in the company for two years when her father,
Thomas Merton, died in the spring of 1991. As the only family member with
experience in the company. Together with her mother, she controlled 65 percent
of the share capital of the firm. The remaining shares were held by her father's
brother and sister, their families, and a few long-service employees. Patricia
Merton was dissatisfied with her company's result over the past year. Since it s
founding in 1950 by Thomas Merton, Merton Electronics had been a distribution
for GEC (General Electronic Company), a large manufacturer of electrical and
electronics products for consumer and institutional markets. Over the years, in
addition to the GEC products, the company had added no competing lines of
electrical appliances, records, compact discs, and cassettes.

In 1980s it began to broaden its product lines by importing Japanese consumer


electronics. Four years later, it entered into an exclusive import agreement with
the Goldstone Corporation of Taiwan, a major producer and dealers throughout a
broad geographical area.

By the beginning of the 1990s, the company had entered into the personal
computer (PC) market, distributing both hardware and software products. It
became the national distributor for Fuji Electronics, a major Japanese
manufactured of PCs and related products in September 1993. This market had
proven to be fast growing, accounting for more the half of total sales, although
only about a third of profits, in 1997; this part of the business was becoming
more and more competitive, as price cutting had become rampant from mail
order and computer discount houses.

The company is facing heavy competition with slowing sales and increasingly
smaller margins. One of the major issues facing the firm is the risk associated
with the import of the foreign goods from Japan. In February 1996, Merton
Electronics was reviewing its currency risk position. Its principal foreign suppliers
were Japanese and fluctuations of the dollar/yen exchange rate during the past 2-
3 years seemed to have had a serious impact on costs and earnings.

There are so many issues facing exporters, importers and others active in
international trade. One of the things that continued to disturb her was the

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volatility of yen and Taiwanese dollar. Due to the international nature of Merton
Electronics' Business these problems occur and create serious impact on costs
and revenue. Actually company was facing very high degree of currency risk.
Currency risk is simply the degree to which the business is affected both
positively and negatively by changes in exchange rates. It can refer to potential
losses in investments, business transactions, and operating expenses due to
fluctuations in exchange rates.

In this case, Merton is suffering from currency risk on payable accounts used to
finance imports from Japanese suppliers. The exchange rate has been moving
against Merton opening themselves up to a loss of over $900,000 in payments to
the Japanese suppliers. Currency risk exposure can be further defined as
translation exposure, transactional exposure, and operating exposure. This case
also tells us to understanding foreign exchange, futures and options market
information.

Finally, Merton Electronics is facing transaction exposure in regard to the payable


to the Japanese firm for the goods that were ordered in January. Merton has
different types of hedging from various options available to them and has to be
careful in choosing the right type of hedging to maintain and resolve the currency
risk exposure.

SWOT Analysis
In Merton Electronics Corporation have so many strengths, weaknesses,
opportunities and threats. We have to make SWOT analysis are as following:

Strengths:

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 Since its founding in


1950 by Thomas Merton, Merton Electronics had been a distribution for GEC
(General Electronics Company), a large manufacturer of electrical and
electronics products for consumer and institutional markets.
 In 1980s it began to
broaden its product line by importing Japanese consumer electronics.
 Four Years later, it
entered into an exclusive import agreement with the Goldstone Corporation of
Taiwan, a major producer of television and other electronic equipment.

 By the beginning of
the 1990s, the company had entered into the Personal Computer (PC) market,
distributing both hardware and software products.
 It became the
national distributor for Fuji Electronics, a major Japanese manufacturer of PCs
and related product in September 1993.
 In 1997 sales had
risen by over 12 percent compared to the previous year, very close to budget.
 During the first
weeks of 1998, Merton had been taking advantage of the relative calm that
usually marked that time of the year.
 The popularity of
the Fuji products, they had been able until 1995 to increase prices to partially
offset their higher dollar costs.
 Since 1996, Merton
had systematically hedged each yen purchase order; purchases from
Taiwanese suppliers were no hedged.

 Merton Electronic
Corporation has a strong historical background and now Patricia Merton a only
experienced president working in this company.

Weaknesses:

 At the same time,


1997 earning fell by more than 40 %, reflecting increasingly difficult market
conditions.
 Margins had been
flat or falling for the past three years, but 1997 was worst.

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 One of the things


that continued to disturb Patricia Merton was the volatility of the yen, and
more recently, the Taiwanese dollar.
 Typical of Merton's
Japanese suppliers, Fuji Electronics had always insisted on invoicing in yen.
 Two years earlier,
toward the end of January 1996, concerned that the falling margins were at
least partially due to the impact of a rising exchange rate.
 Patricia Merton's
General Manager Charles Brown did not prepare a detailed analysis of
purchases before 1995; he estimated that "losses" were, if anything
considerably larger.
 Merton was facing
significant currency risk.

 Merton Electronics
imported a higher portion of its product form Japan than some of its principal
competitors, its profit margin were much more sensitive to the value of the
yen.

 Somewhat
defensive he maintained that since neither he nor anyone else could have
accurately predicted how the yen-dollar exchange rates would have moved
during the past two years.
 When second time
Patricia Merton asked to her General Manager Brown to look at their
experience over the past year, going back to January 1997.
 Although the yen
was still volatile, it had mainly weakened against the dollar during this period.
By Hedging, the dollar cost of yen purchases had about $25.5 million during
1997.
 Besides going over
the hedging instruments, the banker raised a number of other issues for
Merton consider. The company imported goods from its Japanese suppliers on
a continuous basis throughout the year.
 Merton's banker
concluded by stressing that there was no "correct" hedging approach.

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Opportunities:

 Operational
improvements had been maintained, keeping working capital and cash needs
under control.
 Merton had secured
additional long-term financing and an increase in the company's credit line.
 Although continued
growth would require additional investment in new computer and office
equipment and other fixed assets.

 By looking Merton
Electronics issues the banker advised them to hedge their yen purchases.

 If the purchases
had not been hedged, but the yen bought on the spot market when the
invoices came due, the dollar cost would have been about $24.6 million- an
almost $900,000 difference.
 By following Patricia
Merton's banker recommendation not to hedge the Taiwanese dollar purchase,
the U.S dollar cost had been lower in 1997 by some $125,000.

 Banker admitted
that, with hindsight, not hedging would have been the best policy over the
past one to two years. This meant that Merton would have bought the foreign
currency on the spot market each time payments to the Asian Suppliers were
made.

 Quickly checking
the numbers, he noted that if the ¥880 million worth of goods on order or
already invoiced at the end of January were to be settled at current spot rate
of ¥127, this would cost Merton about $6.93 million.
 Merton as a
president and major shareholder of the company thought to revive the
alternative courses that the company might follow.

 Although the
company had been using forward contracts for some 18 months to hedge the
yen purchase, Merton felt she needed to have her memory refreshed and
asked the banker to outline once again how the different hedges worked.

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 According to the
banker, there were two basic choices when hedging. First one it could "Lock
In" today an exchange rate that would be close to the current spot rate; the
forward contracts they had been using provided this type of hedge.

 Second one they


could enter into an option contract that would set an upper bound on the cost
of yen but allow them to take advantage of cheaper yen if that should happen
by the time the invoices had to be paid.
 The option would
provide some of the advantages of not hedging and limit the disadvantages-
but at a cost.
 There were three
ways to lock in an exchange rate: a forward contract, a money market
transaction, and a currency future contract.
 The currency option
contract was available from either banks or exchange.
 Bank or OTC (Over-
the-Counter) options can be tailored into meet the client's precise needs for
maturity, amount or currency.
 Merton's banker
pointed out that besides dealing in "Plain Vanilla" (Standard) call and put
options, he could also offer them Synthetic Exotic instruments.
 Synthetics were
combinations of calls, puts and sometimes forward contracts that were
designed to meet particular risk/return objectives of a client. A so-called a
cost option is one of the more widely used of these.
 Exotics were
options that had some particular feature that gave the buyer a lower premium
at price of more risky payoff.

Threats:

• Merton expected
that continued growth would require investment in computer, office
equipment and other fixed assets could be largely financed out of cash flow- if
margins did not deteriorate further and working capital could be kept in line
with sales.

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• Personal Computer
(PC) market had proven to be fast growing, accounting for more than half of
total sales, although only about a third of profits, in 1997; this part of the
business was becoming more and more competitive, as price cutting had
become rampant from mail order and computer discount houses.
• At the beginning of
their agreement, Goldstone Corporation ha invoice in U.S. dollars but on the
other hand Fuji Electronics had always insisted on invoicing in yen.
• As for purchases
from the Taiwanese suppliers, the banker told them the Taiwanese authorities
managed their currency so that it stayed more or less fixed to the U.S. dollar,
that even if it were to move it was likely to depreciate and for these reasons
hedging would not be worthwhile.
• Merton's second
meeting with her banker and told him that since neither he nor anyone else
could have accurately predicted how the yen-dollar exchange rate would
moved during the past two years, because hedging the exposures was the
most prudent policy for Merton.
• At that time
economic and political uncertainty in Japan and the rest of Asia.

• Merton asked to her


banker that what was the reasons that you had not encouraged them earlier
to hedge the Taiwanese dollar payments, then the banker recalled his advice
at the time was that it had been basically pegged to the U.S. dollar for several
years and anyway was difficult to hedge satisfactorily because of exchange
controls imposed by the Taiwan Authorities.
• Instead of
numerical calculation of $6.93 million, the company was already committed to
pay $7.04 million since these purchases had been hedged when the goods
were ordered. In other words, hedging appeared to have cost them some
$110,000 at the present time.

Findings
After SWOT analysis we have to reach on findings. We have observed different
strengths, weaknesses, opportunities and threats. Now we have able to explain
some findings in Merton Electronics Corporation case are as following:

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 Currency risk exposure is the dollar amount that is at risk if exchange


rates move in an unfavorable direction.

 A company has currency exposure when the currencies for its


expenditures and revenues are not the same.

 Future payments or distributions payable in foreign currency carry the risk


that the foreign currency will depreciate in value before the foreign currency
payment is received and converted into US dollars.
 The company is facing heavy competition with slowing sales and
increasingly smaller margins.
 One of the major issues facing the firm is the risk associated with the
import of the foreign goods from Japan.
 There are so many issues facing exporters, importers and others active in
international trade. One of the things that continued to disturb her was the
volatility of yen and Taiwanese dollar.
 Merton Electronics is facing transaction exposure in regard to the payable
to the Japanese firm for the goods that were ordered in January.
 The falling margins were at least partially due to the impact of a rising
exchange rate.
 Merton's banker
concluded by stressing that there was no "correct" hedging approach.
 Although the
company had been using forward contracts for some 18 months to hedge the
yen purchase.
 There were two
basic choices when hedging. First one it could "Lock In" today an exchange
rate that would be close to the current spot rate; the forward contracts they
had been using provided this type of hedge.

 Second one they


could enter into an option contract that would set an upper bound on the cost
of yen but allow them to take advantage of cheaper yen if that should happen
by the time the invoices had to be paid.
 There were three
ways to lock in an exchange rate: a forward contract, a money market
transaction, and a currency future contract.
 Synthetics were
combinations of calls, puts and sometimes forward contracts that were

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designed to meet particular risk/return objectives of a client. A so-called a


cost option is one of the more widely used of these.
 Exotics were
options that had some particular feature that gave the buyer a lower premium
at price of more risky payoff.
 One such area of
particular risk is known as transaction risk and is associated with foreign
exchange rates.

Company's Transaction Analysis


A company has currency exposure when the currencies for its expenditures and
revenues are not the same. Future payments or distributions payable in foreign
currency carry the risk that the foreign currency will depreciate in value before
the foreign currency payment is received and converted into US dollars. Although
there is a chance for profit, most businesses and lenders give up that chance in
order to eliminate the risk of currency exchange loss. It is measured as the
amount in receivables or payables the company has committed to, for which the
exchange rate has not been determined.

A currency is exposed to exchange rate fluctuations to the extent that it is used


to conduct transactions with external markets. The greater the proportions of
“inter-currency” exchange to total monetary transactions for a given market, the
greater the exposure to changes in exchange rates. Businesses conducting
international trade are exposed to exchange rate fluctuations in proportion to
their total volume of transactions. As the magnitude of “inter-currency
transactions” increases relative to aggregate transactions, a business unit realizes
greater exposure to exchange rate fluctuations.

By defining currency exposure as the proportion of “inter-currency transactions”


to total transactions, greater management attention can be aimed at operations
with a high degree of exposed risk to exchange rate changes.

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Currency Risk Exposure

If Merton Electronics were to not hedge their currency risk exposure, the value of
their payables will fluctuate with the value of the Yen. As can be seen in the
graph below, if the Yen appreciates against the dollar, Merton will lose money due
to their exposure. If the Yen depreciates, Merton will make a profit due to their
exposure.

By entering into a forward contract hedge, Merton could lock in the exchange rate
that they will pay in three months, now. This exchange rate would be $0.7952
per ¥100. Therefore, Merton could eliminate the risk of the Yen appreciating.
However, if the Yen depreciated, Merton has forfeited these possible gains.

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Currency Risk Exposure

If Merton were to use the money market hedge, it would need ¥297,200,642.5 in
order to have ¥300,000,000 in 90 days. This means that Merton will need to put
$2,332,727.84 into a Yen money market account. The interest on this loan will be
$51,591. By doing this, Merton can again eliminate the risk of the yen
appreciating before payment is due but takes the risk that the yen will
depreciate.

If Merton uses the yen futures hedge, it would need to purchase 24 contacts. If
the Yen depreciates, Merton can wait until the futures mature and take the yen to
pay suppliers. If the Yen appreciates, Merton will have to pay their suppliers more
than three months earlier but the cost will be offset by the gain in Merton’s
futures. Therefore, again Merton can eliminate the risk of the yen appreciating
but runs the risk of the yen depreciating and not benefiting.
If Merton purchases April options on the CME, it would incur a cost of $62,400.
However, this is the most that Merton could lose. If the yen appreciates, Merton
will exercise the call options and take delivery of the yen used to pay its
suppliers. If the yen depreciates, Merton will let the options mature unexercised,
and buy yen on the spot market. For this higher up front cost, Merton has
eliminated most of its risk.

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Currency Risk Exposure

Merton could also purchase 90-day yen call options over the OTC market. These
options would cost $74,700 and would work the same as the CME options. If the
yen were to appreciate, Merton would exercise the options at an exchange rate of
$0.7968 and take delivery of the yen to pay suppliers. If the yen depreciates,
Merton would not exercise the options but buy the yen on the spot market in
three months.

A company may find that they are uncomfortable with the risks associated with
changing interest rates on their debt. This can come in the form of interest rates
on the company’s debt and can be handled through the use of an interest rate
swap.

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Currency Risk Exposure

As far as the hedging is concerned, Merton lost around $900,000 due to wrong
hedging decisions. Instead of hedging Taiwanese dollars, they hedged Japanese
yen, which devalued compared to U.S. dollars. Merton should have locked the
Taiwanese dollar at a particular rate with the bank while they should have
purchased the Japanese yen at the spot rate from the market. Since they are
exposed to a 90-day currency risk, we believe they should hedge at the time
when the order is placed. We are recommending this specifically taking in to
consideration Merton’s current financial conditions. Looking at the Merton balance
sheet (exhibit2), it is quite evident that the amount of Accounts payable ($
3,670,000) in foreign currency is quite high. It means that if they don’t hedge
their funds and buy the yen at the spot rates, then at that time there is a fair
amount of uncertainty tied with it. In case the yen becomes stronger in
comparison to dollars then they will have to pay a huge amount of money, which
will further squeeze profit margins and they will be left with little funds. If they
hedge their funds then they at know how much they have to pay. Even when we
consider their assets and the cash that they have in their hands, it is not very
large. This means that they often revert back to their short term financing to
match their working capital with the accounts payable requirements. Instead of
locking in the funds at the forward rates, they should go for the “yen future
hedge” traded on the Chicago Mercantile Exchange (CME) or the Over the
Counter (OTC). This will give them the flexibility to trade their instrument if yen is
forecasted to appreciate in the near future.

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Implementation

Foreign Currency Risk: Minimizing Transaction Exposure

For both in-house and retained international counsel, a thorough knowledge of


international risk exposure techniques can serve as an effective way to
supplement legal strategies for clients involved in international business
transactions. While creative and thorough legal drafting can go a long way to
reduce some international transactions risks, many business risks can be obviated
in whole or in part by the financial markets. One such area of particular risk is
known as transaction risk and is associated with foreign exchange rates.

The Foreign Exchange Market


The foreign exchange market comprises the spot market and the forward or
future market. The spot market is for foreign exchange delivered in two days or
less. Transactions in the spot market quote rates of exchange prevalent at the
time of the transactions. A bank will typically quote a bid and offer rate for the
particular currency. The forward market is for foreign exchange to be delivered in
three days or more. In quoting the forward rate of currency, a bank will use a
rate at which it is willing to buy the currency (bid) and a rate at which it will sell a
currency (offer) for delivery, typically one, two, three or six months after the
transaction date.

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Non-Hedging Techniques to Minimize Transactions


Exposure
Two obvious ways in which transactions exposure can be minimized, short of
using the hedging techniques described below are:
1. Transferring exposure
2. Netting transaction exposure

 The first of these is premised on transferring the transaction exposure to


another company.

 A second way in which transaction risk can be minimized is by netting it


out. This is especially important for larger companies that do frequent and
sizeable amounts of foreign currency transactions.

Reducing Short-Term Foreign Currency Risk


For the company that wants to eliminate short-term transaction exposure
(exposure of less than one year), a variety of hedging instruments are available
at varying costs to the company.

Forward Contracts
The most direct method of eliminating transaction exposure is to hedge the risk
with a forward exchange contract. Forward rate contracts are often inaccessible
for many small businesses. Banks often tend to quote unfavorable rates for
smaller business because the bank bears the risk the company will not fulfill the
forward rate contracts. Large spread in the forward rate quote suggests
unfavorable offer terms. Banks will refuse to offer forward contracts at any rate
to uncreditworthy companies. Companies those are not eligible for forward rate
contracts have the option, however, of hedging transaction exposure with futures
contracts.

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Futures Contracts
In principle, no differences exist between a futures market hedge and a forward
market hedge. When the futures contract increases in value, the company loses
that amount. When the futures contract decreases in value, it gains that amount.

Despite their advantages, futures contracts also contain some disadvantages.


Because futures contract are marked to market on a daily basis, any losses must
be made up in cash on a daily basis, while the offsetting gain on the currency
transaction will be deferred until the transaction actually occurs. This imbalance
can result in a severe liquidity crisis for small companies and for individuals.

Another disadvantage of using futures contracts for hedging is that they trade
only in standardized amounts and maturities. Companies may not have the choice
of timing their receivables and payables to coincide with standardized futures
contracts. Consequently, the hedges are not perfect.

Hedges Using the Money Market


A company has the alternative of using a money market hedge if forward market
hedges are not available or too expensive, and where a futures market hedge
carries too much risk of insolvency. A money market hedge—called that way
because it necessitates borrowing or lending in the short-term money market—
enables a company with a future receivable or a future payable to make the
required exchange of currencies at the current spot rate. In this case, even if
forward and futures contracts are available, a money market hedge may be the
least costly hedging alternative.

Options
Currency options give one party the right, but not the obligation, to buy or sell a
specific amount of currency at a specified exchange rate on or before an agreed-
upon date. If the exchange rate moves in favor of the option holder, the option
can be exercised and the holder is protected from loss. On the other hand, if the
rate moves against the holders, it can let the option expire, but profit, by selling
the foreign currency in the spot market. Consequently, options are best
characterized with potential for gain and no downside risk. Hedging in the options
market enables businesses and individuals to reduce loses caused by unfavorable
exchange rate changes, while preserving gains from favorable exchange rate
changes. However, this flexibility has a cost.

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Currency Risk Exposure

Cross Hedging
Thus far, a market for forward rates, futures contracts, credit or options in the
foreign currency being hedged has been presumed to exist. But this may not be
true in all cases, especially for small developing countries. In such cases, cross
hedging may be the only hedging alternative available.

Cross hedging is a form of a hedge developed in a currency whose value is highly


correlated with the value of the currency in which the receivable or payable is
denominated. In some cases, it is relatively easy to find highly correlated
currencies, because many smaller countries try to peg the exchange rate between
their currency and some major currency such as the dollar, the franc or euro.
However, these currencies may not be perfectly correlated because efforts to peg

values frequently fail.

Mitigating Long-Term Currency Risk Exposure


Theoretically, the same hedging instruments discussed above to alleviate short-
term currency risk can be used to hedge long-term transaction exposure.
However, at present, there is a limited market for currency futures options with
maturities greater than one year.

Back-to-Back Loans
Multinational corporations can often reduce their respective long-term currency
risk exposure by arranging parallel or back-to-back loans. Under this
arrangement, the companies are entering into a purely bilateral arrangement
outside the scope of the foreign exchange markets. Neither company is affected
by exchange rate fluctuations. Nevertheless, both companies remain exposed to
default risk because the obligation of one company is not avoided by the failure of
the other company to repay its loan.

Currency Swaps/Credit Swaps


Swaps are like packages of forward contracts. Currency swaps can be used to
avoid the credit risk associated with a parallel loan. In broad terms, a currency
swap is an agreement by two companies to exchange specified amounts of
currency now and to reverse the exchange at some point in the future. The lack
of credit risk arises from the nature of a currency swap. Default on a currency
swap means that the currencies are not exchanged in the future, while default on

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a parallel loan means that the loan is not repaid. Unlike a parallel loan, default on
a currency swap entails no loss of investment or earnings. The only risk in a
currency swap is that the companies must exchange the foreign currency in the
foreign exchange market at the new exchange rate.

Recommendations
We as a team recommend that Merton should do their budgeting once a month if
possible or at least as frequently as possible. This is very important as they buy
most of their goods from Asia and they have to make all their payments in
foreign currency. Since the currency market is highly volatile, they will have to
keep track of the past trends in Japanese yen and the Taiwanese dollar. If they
fail to do this they will fall into a big trap as they have already had huge losses in
the present situation. It is important to mention here that the losses they have
made of $900,000 dollars exactly match their pre-tax profits (exhibit 2). If they
can come up with right kind of mix of hedging and buying the currency at the
spot rates, Merton can double their profits and they will not have to worry about
the future competition in the market.

On the question of whether they should go for a full hedging strategy or just
hedge part of the total foreign currency payments greatly depends on the
company’s objective. If the risk in the near future is very high and the political
situation in a particular country, (e.g. Japan) is not stable then they should
certainly hedge the yen as it is a safe bet rather then to expose themselves to the
uncertain risk of having a significant loss. Review of the currency market is of
supreme importance as it changes with even a single piece of information.
Chances are there that a nonfinancial company with limited competence in this
area will loose often rather than make profits. So Merton will have to be careful in
choosing the right type of hedging from the various options available to them.

Speculation regarding derivatives is usually risky. However, companies with a


comparative advantage can make profits speculating because they have an edge
over the other market participants. This edge may come in the form of expert
traders, superior models, or some other advantage. Therefore, nonfinancial
companies should not try to speculate in order to make money from currency or
interest rate movements. They do not have the needed advantage to make
money or a proper understanding of the risks involved. Speculating in derivatives

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is also probably beyond the acceptable risk of the company’s owners. If they were
interested in trading derivatives, they could do so themselves or invest in an
investment bank that speculates on currency or interest rate movements.

A nonfinancial company may want to try to speculate in order to profit from


movements in commodity prices. If the company produces, distributes, or deals
with the commodity in another way, it may have knowledge of the commodity
that will give it an edge and enable it to make profits from commodity
derivatives. However, the company should be aware of the risks involved with
speculating. For example, many energy producers and distributors recently
became involved with trading energy and energy derivatives. Many of these
companies have had trouble measuring the risks involved with speculating.

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Currency Risk Exposure

Conclusion
The risk of currency exposure can be mitigated or even eliminated in its entirety
by the techniques and instruments described in this article. How much currency
risk exposure remains depends on the instrument selected. Many instruments do
not hedge transaction exposure perfectly, but are more accessible to the
individual and small to medium size companies. Instruments used to more
completely hedge currency exposure, such as put and call options, may contain
sizeable transaction costs.

In final words, a company should not speculate about movements in currencies,


interest rates, or commodities unless it has a comparative advantage over the
other market participants and fully understand the risks. This is difficult for
nonfinancial companies because financial companies have many resources such
as skilled traders and sophisticated models that give them the edge.

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Currency Risk Exposure

References
1.http://www.ecch.com/casesearch/product_details.cfm?id=8581
2.http://students.clarku.edu/~adowns/portfolio/Financial
%20Modelig/Derivatives-Merton%20Electronics.pdf
3.http://knowledge.insead.edu/abstract.cfm?ct=4422
4.http://termpaperaccess.com/doc_merton_electronics_ksrpk.html
5.http://papers.ssrn.com/sol3/papers.cfm?abstract_id=128112
6.http://www.oppapers.com/essays/Merton/190705
7.Remmers , Lee Lee, Merton Electronics (1996). Available at SSRN:
http://ssrn.com/abstract=128112
8.http://www.vsb.org/publications/valawyer/june_july01/kelley.pdf

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Currency Risk Exposure

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