Pixonix Inc- Addressing Currency Exposure

On Friday, November 2, 2007, Mikalya Cain, Chief Financial Officer of Pixonix Inc., sat in
her office and pondered the impact of the strong Canadian dollar on her firm’s projected
financial results. The Report on Business today stated that the Canadian dollar had hit another
record, jumping to US$1.0717 from the previous day’s close of US$1.0512after a stronger
than expected jobs report reduced the odds of an interest- rate cut. The Canadian dollar had
already been the world’s best performing major currency this year, increasing 25% against
the U.S dollar and almost seven per cent in the past month alone. Cain knew she would have
to understand the impact of the strong dollar on her firm’s cash flows and the tools available
to manage the company’s currency risk.

The Company

Pixonix was a graphic design company that operated in Toronto, Canada. At the annual cost
of USD 7.5 million, the company licensed proprietary tools and software through a U.S
company; this payment was due at the end of January each year. While all of the company’s
revenues were denominated in Canadian dollars, a significant portion of its expenses were
paid in U.S dollars. Therefore, Pixonix had to annually convert its Canadian dollar cash flows
into U.S dollars. As the Canadian dollar strengthened, cash flow and profitability had been
positively impacted, but Cain faced a considerable amount of uncertainty about the value of
the Canadian dollar at the end of January, when she would have to purchase USD 7.5 million.

Recent History of the Canadian Dollar

At times during the early 1970s’, the value of the Canadian dollar was higher than that of the
U.S dollar, reaching a high of USD 1.0443 on April 25, 1974. During the technological boom
of the 1990s, the Canadian dollar fell relative to the U.S dollar and traded a record low of
USD0.6179 on 21 January, 2002. Since then, its value had risen, in part due to the high price
of Canada’s commodity exports (primarily oil). The Canadian dollar’s value against the U.S
dollar rose sharply in 2007, owing to the continued strength of the Canadian Economy and
the U.S currency‘s recent weakness. On September 26, 2007, the Canadian dollar was
trading at parity with the U.S dollar for the first time since November 25, 1976. On
September 28, 2007, the Canadian dollar closed above the U.S dollar for the first time in 30
years and had today hit an all-time high since official record keeping began. RBC, the largest
international trader of Canadian dollars, raised its forecast for the currency on Friday, saying
it would appreciate further to around USSD 1.08 before declining below parity in the second
half of next year.

Hedging Vehicles and Potential Strategies

Cain had investigated various vehicles for hedging the company’s foreign exchange risk,
including call options, put options and forward contracts. Cain had two strategies in mind to
address the firm’s currency exposure. The first strategy that Cain was considering was to
purchase a forward contract and lock in the cost of the January U.S dollar purchase of USD
7.5 million. Refer Exhibit I for the current forward rate of the U.S dollar. Exhibit II shows the
details on various call and put options of USD.

Exhibit I showing Forward Rates

Spot rate (CAD/USD) 0.9344 0.9351

Period Bid Ask
1 Month 0.934330 0.935130
2 Months 0.934190 0.935010
3 Months 0.934160 0.934990
6 Months 0.934530 0.935510
12 Months 0.935620 0.936700
2 years 0.938660 0.940940
(Source- www.ozforex.com.au, on 2/11/2007)

Exhibit II showing Options

YY MM Strike
07 NOV 0.935
07 NOV 0.94
07 NOV 0.945
07 NOV 0.95
07 DEC 0.935
07 DEC 0.94
07 DEC 0.945
07 DEC 0.95
08 JAN 0.935
08 JAN 0.94
08 JAN 0.945
08 JAN 0.95
Put options are available at the same strike price. Call option premium is 0.0173 cents/USD
and put option premium is 0.0179 cent/USD.

If the most optimistic value of USD is expected to be 0.90 CAN $, most likely to be 1 CAN $
and the most pessimistic to be 1.10 CAN$, how would you evaluate the strategies?
Henderson Corporation

Henderson Corporation, located in Australia, manufactures ball bearings for an entity located
in Singapore. It has just made a shipment to Singapore and expects to receive S$250000 in 30
days. However, the board of directors at Henderson is worried that the Australian dollar will
strengthen significantly in the near term against the Singapore dollar. The current spot rate is
1.26AUD/S$ and expected spot rate after 30 days is 1.22AUD/S$. So it has instructed the
CEO to consider hedging the S$ receivables and bring a proposal for consideration to the
next board meeting. The CEO has asked you to develop the proposal for her consideration.
The proposal needs to consider several hedging alternatives and the relative costs and
benefits of each alternative-

To conduct the analysis you have collected the following information-

a. Current quote from a Singapore bank is that loans can be obtained for S$ @1.5% for
one month and investments in AUD will fetch 2% for one month.
b. S$ put options with an exercise price of $1.31 and with a premium of $0.05 currently
exist. The spot rate for S$ due in 30 days is expected to be 1.28(33% probability) or
1.30(33% probability), 1.32(34% probability).
c. The quote obtained for the 30-day forward rate 1.30 AUD/S$.

There are many ways that this risk can be dealt with and a single way to proceed is hard to
determine. Alternatives include using foreign exchange and options markets or diversifying
sources of sales revenues or production costs. After consideration of the situation you have
decided that three strategies could be pursued- a money market hedge, an option hedge and a
forward hedge. These are the least disruptive to the balance sheet and are relatively short term
in nature, which fits the nature of the risk being managed.