# Hedging and its benefits to shareholders: Business Case

The General Task:

Your team has just been appointed to advice and oversee the Finance Department of a large U.K.-based company (which is either Virgin, Wilkinson or Tesco – you decide). Upon arrival, you notice that your predecessor had not really been up-to-date with respect to recent financial innovations. For example, members of the department tell you that he had a general distrust towards any derivative instruments, and therefore never hedged any existing exposures. In addition, he argued that the firm’s cost of capital could be determined through considering how the firm’s returns commove with the FTSE 500’s returns.

Among all other issues that need to be dealt with, you decide that on top of your list of priorities is to (1) show the members of the Finance Department how an existing exposure in euros can be hedged with a forward contract, to (2) explain to them why hedging makes economic sense, and to (3) determine the company’s cost of capital in an international setting.

Today is the 31st December 2015.

Task 1) Hedging a EUR Exposure:

Your first task is to hedge a foreign currency exposure of EUR 341,000, which will be paid to your company on the 31st March 2016. At your disposal are several foreign currency quotes and 3-month interest rates stored in the file named ‘Data2015.xls’ located in Moodle.

On the 31st March 2016, the GBP/EUR exchange rate can have either increased by 10%, increased by 5%, remained constant, decreased by 5%, or decreased by 10% (5 cases, in total), as also shown in the dataset.

1. Direct Hedge: Hedge the EUR exposure with a GBP/EUR forward contract. To this end, you need to determine the GBP/EUR forward rate. Initially, you are puzzled: you don’t have forward quotes on any currency in your dataset. But then you remember that there exists a relation between forward rates and spot rates…

a) Explain the formula. What is its intuition? How is it derived?

b) What is the rate on a 90-day GBP/EUR forward contract on 31st December 2015?

You want to use the EUR forward contract to hedge your exposure. At first, you seem to remember that to implement a minimum variance hedge, you should run the following regression:

Se_{t+90} = a + b fh_{t+90, maturity} + e, as you can see from lecture V, but you then recall that this is not necessary for a direct hedge…

c) What is the optimal hedge ratio b? Why?

d) For each of the 5 exchange rate scenarios on the 31st March 2016, compute the hedged and the non-hedged cash flow. What is the variance of the non-hedged cash flow? Of the hedged cash flow? Which cases have you made a gain/loss on the forward contract?

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2. Cross-Hedge: Assume there are no GBP/EUR forward contracts. In this case, you could try to hedge the EUR 341,000 with another currency.

a) Choose one of the other foreign currencies. Determine the optimal hedge ratio b for the cross-hedge.

b) For each of the 5 exchange rate scenarios on the 31st March 2016, compute the hedged and the non-hedged cash flow. What is the variance of the non-hedged cash flow? Of the hedge cash flow? In which cases have you made a gain, in which cases a loss on the forward contract?

3. Maturity-Hedge: For this task, assume that there are only forward contracts with a maturity of 6 months, so the forward contract will still have 3 months to go when the EUR 341,000 are received.

a) Determine the optimal hedge ratio b for the maturity-hedge. Hint: you must regress changes in the GBP/EUR rate on changes in the GBP/EUR forward rate with 90 days left to maturity.

This might be a tricky one: assume that the 90-day interest rate is constant throughout 2016, and that the 180-day interest rate is two times the 90-day interest rate.

b) For each of the 5 exchange rate scenarios on the 31st March 2016, compute the hedged and the non-hedged cash flow. What is the variance of the non-hedged cash flow? Of the hedge cash flow? In which cases have you made a gain, in which cases a loss on the forward contract?

Task 2) Explain Why Hedging might be beneficial for Shareholders:

Several colleagues argue that corporate hedging cannot be beneficial to shareholders. They question: “How can adding a zero-value forward contract to the rest of the company’s assets be value-increasing?” As a result, they come to the conclusion that trying to hedge the EUR 341,000 is just a waste of time. Fortunately, you still have the very interesting AcF 305 fresh in your mind, and you can thus explain to your ignorant colleagues that, while a forward contract has an initial value of zero, its impact on other cash flows could make it relevant for shareholders.

Here, you need to show the corporate benefits from using forward/future contracts as a business case. To do that, you would need to use a real-world example where forward/future contracts might have had a positive impact on the value of a company. You would need to clearly explain the problem, how this is related to currency risk (which is the problem faced by the company) and how a forward/future contract could have been used to solve the problem and mitigate currency risk. This business case has to be SHORT, which means that you should take into account the word count.

Ideas about how to write a (LONG!) business case can be found in here:

http://www.skillsyouneed.com/write/business-case.html

BUT KEEP IN MIND YOURS HAVE TO BE SHORT!

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Task 3) Computing the Cost of Capital in an Integrated Market:

As a last step, you would also like to determine the company cost of capital in an integrated, international market (i.e., through use of the International CAPM). To this end, the dataset ‘Data2015.xls’ also contains the equity returns of the three companies (Virgin, Wilkinson or Tesco) and the returns of the FTSE 500 – the market index.

Tasks: Compute the company’s international expected cost of capital.

This task is similar to the first one insofar as your team will need to make computations to derive the international cost of capital. However, I do not give as much guidance for this task as for the others, as I would like you to decide which approach you choose to solve the task. Note: there is no right or wrong approach. There are only approaches which are well-justified and approaches which are not well justified.

To obtain an idea on how to compute a firm’s cost of capital, please refer to chapter 19 in Piet Sercu’s book ‘International Finance – Putting Theory into Practice’.

Once you have computed the expected cost of capital for your company, you need to decide which of the following projects would be more beneficial for shareholders (cash-flows given in HC units)

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Project A

-1000

200

-200

1000

150

800

Project B

-500

350

300

200

300

150

In addition to computing the international cost of capital for your company, you should motivate the use of InCAPM. This is, why should we care about InCAPM?

Design of the Coursework Assignment & Presentation:

The coursework assignment should give the reader a clear understanding about how you decided to solve the various tasks. Be specific, but not repetitive. From your descriptions and the datasets, the reader must be able to replicate your outcomes.

The length of the essay is limited to no more than 2,500 words, excluding plots, footnotes and bibliography (if necessary). Use Times New Roman, font size 12, single-spaced. Excessive length will be penalized. The essay should be clearly structured and should have a professional design. Hence, mind the following guidelines:

1. Each coursework assignment should have a front page, clearly stating students’ names, the title of the assignment, the date the coursework assignment was completed, and other relevant information. The coursework assignment must be stapled, or otherwise kept together. It should be divided into separate sections, such as ‘1. Introduction’, ‘2. Hedging’, ‘3. Concluding remarks’. Use sensible headlines which hint at the content of the separate sections; these should be larger in font size and bold compared to the main text. The main text must be consistently formatted, i.e., avoid modifying the font, size, colour. Use page numbers. You could have a short table of contents or an abstract at the beginning.

2. Numbers should be rounded to two or three digits, e.g. round 1.23456789 to 1.23 or 1.234.

3. While no requirement, students can produce up to three/four tables or figures for this coursework assignment, if they deem this helpful. However, they should produce appealing tables with horizontal (no vertical) lines and indicate which cell contains what sort of information. You could, for example, prepare the tables in EXCEL and then use ‘copy/paste special’ to insert them as a picture into WORD. Number both tables and figures, e.g. ‘Table 1: Total Exports’ or ‘Figure 3: Government Deficit’.

4. The coursework assignment should be kept as short and concise as possible.

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5. Students can include pictures, use shiny, expensive paper, professionally bind the assignment, etc. We do not require this from you, and it is only of secondary importance compared to the content and the style criteria, but it might help to further improve a positive feeling about a coursework assignment.

Note that the items in boldface are the minimum style requirements. Make sure that these are addressed in the coursework assignment. Failure to address these will lead to a reduction of the assignment grade.

Assessment:

All tasks are worth the same number of marks, 30. The remaining 10 marks are assigned by the clarity, correctness and accuracy of your writing.

The final grade of the coursework assignment depends on (1) the standard of your writing, (2) style and design, (3) the correctness of your arguments and descriptions, and (4) your quality of reasoning.

After a reasonable time, the coursework assignment will be returned to you with comments.

Organization:

You have to work in groups. The deadline for the submission is Wednsday (week 10), 14th of December, before noon. Late submissions will be penalized. In addition, you will have to submit your coursework in “pdf” format via Moodle.

Students have to submit a declaration sheet where they confirm (by signing it) that they agree with the University’s regulations relating to plagiarism.

The coursework assignment has to be written in Microsoft Word or a comparable word processor, such as Open Office Word, Scientific Word, MikTex, etc. Hand-written assignments cannot be accepted.

Appendix: Regression

You have to estimate (standard) regressions, also called ordinary least squares (OLS) regressions. There are two ways of estimating a regression in Excel:

• Using “Analysis ToolPak”: ‘Data’ – ‘Data Analysis’ [if ‘Data Analysis’ is not shown, you have to install the Add-In] – ‘Regression’ – ‘OK’ – specify ‘Input Y Range’, ‘Input X Range’ and ‘Output Range’ (you may tick ‘Labels’ but then you need to make sure that the first row of your data range contains the labels) – ‘OK’. If you are estimating a regression with one (more than one) independent variable, the ‘Input X Range’ includes cells from one (more than one adjacent) columns.

• Using a function: =SLOPE(known_y’s,known_x’s) you cannot estimate a regression with more than one independent variable in this way. This function gives you the slope (beta) of the regression model.

For interpretation of regression results, see the optional reading of week 5 (or your material of relevant previous courses).