Academic journal article Journal of the International Academy for Case Studies

Hedging Foreign Currency Transaction Exposure

Academic journal article Journal of the International Academy for Case Studies

Hedging Foreign Currency Transaction Exposure

Article excerpt

CASE DESCRIPTION

The primary subject matter of this case is hedging foreign currency exchange rate risk. Secondary issues examined include assessing transaction exposure 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 3-4 hours of preparation time from the students.

CASE SYNOPSIS

St. Louis Chemical is a regional chemical distributor, headquartered in St. Louis. Don Williams, the President and primary owner, began St. Louis Chemical ten years ago after a successful career in chemical sales and marketing. The company has gradually expanded it product line and network of manufactures. However, a year-end report had shown shrinking profit margins on product lines that include chemicals purchased from a Canadian manufacturer. Williams has asked for recommendations regarding his firm's exposure to exchange rate risk.

INSTRUCTORS' NOTES

CASE OVERVIEW

St. Louis Chemical is a regional chemical distributor, headquartered in St. Louis. Don Williams, the President and primary owner, began St. Louis Chemical ten years ago after a successful career in chemical sales and marketing. During a year-end review, Williams noticed a significant deterioration in the profit margins of many specialty chemical lines. After further investigation, Williams learned their supplier, Norcand Chemical, required all orders to be invoiced in Canadian dollars. As a result of the invoicing policy, St. Louis Chemical was exposed to an average of 90 days of exchange rate transaction exposure. Williams solicited the help of James Thorton, a newly hired assistant in the finance office, in proposing alternatives to manage the exchange rate risk.

The primary subject matter of this case is foreign currency exchange rate risk. secondary issues examined include assessing transaction exposure and comparing hedging techniques to effectively manage 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.

TASKS TO BE PERFORMED

1. Calculate the percentage change in the #CAD/1USD exchange rate between the order month and invoice month for past transactions. Determine the US dollar cost differ ence per transaction between the estimate used by Packmore and the in voice paid by Scott. Explain the effect of exchange rate movements on profit margins during 2005.

During the first 6 months of 2005, the exchange rate risk had benefited St. Louis Chemical. A modest strengthening of the US dollar that had occurred for orders placed from October 2004 to March 2005 but paid for from January to June 2005 meant that St. Louis Chemical had actually paid a total of $18,260 less for Norcand orders compared to costs Young entered at the time of the orders. Unfortunately, the last 6 months of 2005 had provided a much different outcome. Orders placed from April to September of 2005 and paid for from July to December 2005 had resulted in actual payments of $46,390 more than costs entered in by Young. The US dollar cost difference is a function of the percentage change in the value of the dollar and the size of the order placed. Looking at all of 2005, St. Louis Chemical had actually paid $28,130 more for Norcand orders compared to cost estimates used by Packmore, thus reducing the already thin profit margins characteristic of the industry.

2. For the C$300,000 December 2005 order, determine a probability distribution of the US$ cost to St. …

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