Case 37 Note Essay

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Pages: 4

Case #37
Baker Adhesives Synopsis and Objectives

Baker Adhesives (Baker) has just made its first foray into international sales and must come to grips with the impact of exchange-rate changes on the profitability of a past order. The company must also formulate a strategy for dealing with exchange-rate risks for future orders. The case is intended as an introduction to exchange-rate risk and the management of that risk. Upon receipt of payment from a past order, the firm realizes that exchange-rate movements have reduced the value of the sale. A follow-on order provides the context for exploring possible mechanisms for managing that risk. In particular, sufficient direction and information is provided to examine both a forward
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For a money-market hedge, the steps look like:

Foreign Currency Outflow(payable) | | Foreign Currency Inflow(receivable) | | | | * Convert on spot market to foreign currency * Invest in money market * Pay outflow with maturing investment | | * Borrow on money market * Convert on spot market to domestic currency * Use inflow to pay off loan when due |

We are trying to compare the two hedged cash flows (in present value terms) to the unhedged (expected) cash flow. Which one provides the largest expected cash inflow? Once we figure this out, we can evaluate the options better. However, there is no standard procedure for weighing the benefits of hedging risks.

Market parity:

The interest rate parity condition is:

1 + rdomestic | = | Forward | 1 + rforeign | | Spot |

where the rates are quoted as the domestic price of the foreign currency. The rates must be for the same duration as the forward contract (in this case, three months). We can use effective three-month rates calculated from the annual effective interbank rates. Also, because the forward rate from the bank is essentially a bid quote, to be consistent, we use a bid quote for the spot rate. We can verify that the markets are essentially in parity:

It is also common to evaluate parity by asking whether the forward premium or discount offsets the interest differential. The