Hedging with Foreign Currency Options at Pearson Inc

Article excerpt

CASE DESCRIPTION

The primary subject matter of this case is hedging foreign currency exchange rate risk using foreign currency options. Secondary issues examined include evaluating financial risk and comparing hedging techniques to effectively manage unwanted exposure. The case requires students to have an introductory knowledge of accounting, statistics, finance and international business thus the case has a difficulty level of four (senior level) or higher. The case is designed to be taught in one class session of approximately 3 hours and is expected to require 4-5 hours of preparation time from the students.

CASE SYNOPSIS

Pearson Inc is a US based company specializing in corporate travel services. Recent product line additions have exposed the company to more significant foreign currency exchange rate risk. In addition, the unique structure of Pearson's business model has led the company president, Mike Pearson, to consider currency options in addition to traditional forward currency hedges. Pearson would like an evaluation of the company's increased foreign currency exposure and a proposed strategy for eliminating unwanted exchange rate risk before the next product catalog is published.

BACKGROUND

Employees engaged in corporate sales make up approximately 12% of the fulltime workforce in the United States. Corporations spend over one trillion dollars annually on sales force expenditures, more than they spend on any other promotional method. Given the high cost and importance of the personal selling function, a key managerial concern is about motivating people to achieve higher levels of performance. Incentives like sales contests are generally seen as an important tool to motivate sales people to achieve goals that surpass those associated with normal compensation, enhance job satisfaction, and increase corporate profits. Sales incentives promotion is an industry that exceeds $127 billion annually. Awards associated with sales contests generally fall into one of three categories - cash, merchandise, and travel.

Growth in travel awards exploded during the 1990's, only to drop off as the technology industry fell apart in 2000 and the 9/11 terrorist attacks of 2001 made travel as a reward less appealing. However, the all-expense paid vacation for employees achieving specific benchmarks is making a comeback as a popular incentive award recently. The Incentive Marketing Association estimates that corporate America spent about $30 billion on travel rewards alone in 2006. In addition, there has been a significant change in the destinations and type of activities people are doing with incentive travel. The trend in this industry is shifting to a desire for more exotic international travel options.

Pearson Inc is an Atlanta based company specializing in corporate travel services. Their focus is primarily on incentive initiatives, customer loyalty programs, and meetings and event management. Founded in 1986 by Mike Pearson, Pearson Ine has two main divisions. The corporate event group is a higher volume/lower margin division that specializes in large group travel outings, such as training seminars, conferences, and annual meetings. The incentive travel group is a lower volume/higher margin division that provides travel packages mostly associated with sales contests, customer loyalty programs, and other reward based promotions. In a typical sales contest, a company may set a specific goal for its sales force. Possible objectives may be to increase sales, generate new accounts, launch new products, liquidate inventory or expand into new territories. The company will then define precisely what the sales force needs to accomplish, whether its percentages, number of units, profits or some other concrete measurement and employees who achieve stated goals will earn rewards such as travel packages.

THE SITUATION

By and large, the incentive travel division at Pearson works off a catalog business. …