Merton Electronics Corp

1. Merton Electronics Corp • By Alexzander Downs • Michael Jordan • Kevin Grant • Takshal Bhansali

2. Outline • Current Situation • Currency risk exposure • Each hedging method defined • What happens if • Hedging if and when • speculation • conclusion

3. Current Situation • Merton’s sales has grown by 12% but the earnings fell by 40%. • The competition is intensifying due price cutting by the competitors. • More then 60% of the total sales are imported from Asia. • Payments have to be made in either yen or Taiwanese dollars. • In last 18 months Merton has hedged at the future rates.

4. Why is this a problem?

5. Currency risk exposure if left unheadged the dollar value of the payable is subject to fluctuations in the value of the Yen value at the current forward price is $2,385,600

6. Each hedging method defined • According to the banker there were two basic choices

7. Each hedging method defined • Forward Contract Hedge • Merton has committed themselves to pay ¥300,000,000 in 90 days ¥300,000,000 x $.7952 = $2,385,600 100

8. Each hedging method defined • Money Market Hedge • Buy yen today on the spot market and place in a yen time deposit until needed to pay suppliers. • ¥300,000,000 = So e^(.0375) (.25) • So = ¥297,200,642.50 • Convert ¥297,200,642.50 into dollars • ¥297,200,642.50 x $.7849 = $2,332,727.84 100

9. Each hedging method defined • We now need to know how much it is going to cost Merton to borrow $2,332,727.84 for 90-days. • Fo = $2,332,727.84 e^(.0875)(.25) • Fo = $2,384,318.48

10. Each hedging method defined • [OTC] 90-day [OTC] 90-day Yen Call Option • ¥300,000,000 x .0249 = $74,700 100 Max (St – K, 0) $74,700 (St .7852, 0)

11. Each hedging method defined • Yen Futures Hedge [CME] • ¥300,000,00 = 24 contracts 24 contracts x .0208 = $62,400 12,500,000 100 Max (St - $.80, 0)

12. What happens if • What happens if the company hedges a particular exposure but subsequently finds that the period at risk changes (the exposure is shorter or longer than the hedge, or the amount of risk changes)? • Optimal Hedge Ratio • Roll hedge forward

13. What happens if • If it turns out that Merton needs the forward contract for a longer period they can roll hedge forward. Each time they roll it forward Merton will face basis risk. • Basis = spot price of an asset – its future price • Basis risk therefore is the the uncertainty as to what the basis will be at maturity.

14. What happens if • Swaps • Interest rate Swaps • Currency Swaps

15. Speculation • Companies should have a comparative advantage to profit from speculation. • Nonfinancial companies do not have a comparative advantage at predicting currency and interest rate movements.

16. speculation • A nonfinancial company may want to try to profit from movements in commodity prices. • However, the company should be aware of the risks. • Example: Energy Traders

17. Conclusion • Should prepare budgets monthly due to nature of currency risk. • Merton has a 90 day currency risk exposure so they should hedge when the order is placed. • The extra cost of the options is worth eliminating the risk.

18. QUESTIONS