CASE CURRENCY RISK MANAGEMENT

A Colombian company named Tiburon S.A. has recently decided to expand its international
trade relationship by exporting to the United Kingdom. Swims Ltd., a British retailer, has com-
mitted itself to the annual purchase of 50,000 pairs of Speedos, Tiburon’ primary product, for a
price of £40 per pair. The agreement is to last for 2 years, at which time it may be renewed by
Tiburon and Swims.

In addition to this new international trade relationship, Tiburon continues to export to Thailand.
Its primary customer there, a retailer called SportX, is committed to the purchase of 160,000
pairs of Speedos annually for another 2 years at a fixed price of 5,194 Thai baht per pair. When
the agreement terminates, it may be renewed by Tiburon and SportX.

Tiburon also incurs costs of goods sold denominated in British pound. It imports materials
sufficient to manufacture 300,000 pairs of Speedos annually from the United Kingdom. These
imports are denominated in British pounds, and the price depends on current market prices for
the rubber and plastic components imported.

Under the two export arrangements, Tiburon sells quarterly amounts of 12,500 and 40,000 pairs
of Speedos to Swims and SportX, respectively. Payment for these sales is made on the first of
January, April, July, and October. The annual amounts are spread over quarters in order to avoid
excessive inventories for the British and Thai retailers. Similarly, in order to avoid excessive
inventories, Tiburon usually imports materials sufficient to manufacture 75,000 pairs of Speedos
quarterly from the United Kingdom. Although payment terms call for payment within 60 days of
delivery, Tiburon generally pays for its British imports upon delivery on the first day of each
quarter in order to maintain its trade relationships with the British suppliers. Tiburon feels that
early payment is beneficial, as other customers of the British supplier pay for their purchases
only when it is required.

Since Tiburon is relatively new to international trade, Harald Verstappen, Tiburon’ chief
financial officer (CFO), is concerned with the potential impact of exchange rate fluctuations on
Tiburon’ financial performance. Verstappen is vaguely familiar with various techniques
available to hedge transaction exposure, but he is not certain whether one technique is superior to
the others. Verstappen would like to know more about the forward, money market, and option
hedges. The CFO has asked you, a financial analyst at Tiburon, to help him identify the hedging
technique most appropriate for Tiburon.

Unfortunately, no options are available for Thailand, but British call and put options are
available for £31,250 per option. Verstappen has gathered and provided you with the following
information for Thailand and the United Kingdom:
 THAILAND UNITED KINGDOM
Current spot rate COP 92 COP 6000
90-days forward rate COP 87 COP 5940
Put option premium n/a COP 40 per unit
Put option exercise price n/a COP 5920
Call option premium n/a COP 60 per unit
Call option exercise price n/a COP 5960
90-days borrowing rate 3.75% (nonannualized) 2.1% (nonannualized)
90-days lending rate 2.5% (nonannualized) 1.8% (nonannualized)

In addition to this information, Verstappen has informed you that the 90-day borrowing and
lending rates in Colombia are 2.5 and 1.9 percent, respectively, on a nonannualized basis. He has
also identified the following probability distributions for the exchange rates of the British pound
and the Thai baht in 90 days:

SPOT RATE FOR THE THAI SPOT RATE FOR THE

PROBABILITY BAHT IN 90 DAYS BRITISH POUND IN 90
DAYS
5% COP 81.0 COP 5810
20% COP 85.4 COP 5890
30% COP 86.9 COP 5925
25% COP 87.5 COP 5980
15% COP 91.0 COP 6030
5% COP 93.0 COP 6080

Tiburon’ next sales to and purchases from the United Kingdom will occur 1 quarter from now. If
Tiburon decides to hedge, Verstappen will want to hedge the entire amount subject to exchange
rate fluctuations, even if it requires overhedging (i.e., hedging more than the needed amount).
Currently, Verstappen expects the imported components from the United Kingdom to cost
approximately £10 per pair of Speedos. Verstappen has asked you to answer the following
questions for him:

1. Which type of currency risk is Tiburon exposed to? Explain your answer.

2. Does Tiburon have a long or a short position in regards to the British pound? Explain your
answer.

3. Using a spreadsheet, compare the hedging alternatives for the Thai baht with a scenario
under which Tiburon remains unhedged. Do you think Tiburon should hedge or remain
unhedged? If Tiburon should hedge, which hedge is most appropriate?
4. What is the most important difference between a forward market hedge and an options
market hedge?

5. Suppose that during this 90-day period, the Thai baht strengthens (= appreciates) against
the Colombian peso. Assuming neither Tiburon nor SportX hedge against currency risk,
what would be the currency gain or loss for each party as a result of this transaction?

Tiburon Swims
A. No gain or loss Gain
B. Gain No gain or loss
C. No gain or loss Loss
D. Loss No gain or loss

6. Using a spreadsheet, compare the hedging alternatives for the British pound with a scenario
under which Tiburon remains unhedged. Do you think Tiburon should hedge or remain
unhedged? Which hedge is the most appropriate for Tiburon?