Great Eastern Toys Case

Hedge Strategy Recommendation

After evaluating the hedging options presented to us by Mr. Wu, I have determined that the most prudent strategy for Great Eastern Toys (GET) in limiting its exchange rate exposure is to short the forward contract. The reasons for this are detailed below.

Forward contracts neutralize the risk of DM depreciation by fixing the exchange rate for our DM denominated receivables at HK$4.3535/DM. Option contracts on the other hand provide insurance. Options protect the company against future adverse exchange rate movements while allowing for the benefit of an appreciation of DM. However, unlike forward contracts, options require payment of an up-front fee. The premium for the put option @ July 15 is HK$ 252,000 (DM 4,000,000 * HK$ 0.063/DM). Therefore, GET must pay HK$ 252,000 upfront should we choose the put option. However, given that GET has significant working capital needs and is unable to access external capital as a result of the credit squeeze, the put options is not in the best interest of the company.

The put option is more profitable to the Company than shorting the forward contract when the HK$/DM exchange rate is greater than HK$ 4.4186/DM. Based on a simulation that showed the expected HK$/DM exchange rate in 90 days, the probability that the exchange rate would exceed HK$ 4.4186/DM is approximately 30% percent. So on average the forward strategy is better than the option strategy. Below the HK$ 4.4186/DM exchange rate, the forward contract is always more profitable than the option contract.

The Value of the put option when S (Spot Rate) < K (Strike Price):

FV (the upfront payment) @ October 15= HK$ 4,000,000 * HK$ 0.063/DM * (1 + (0.1325 * (90/360)) = HK$ 260,348

Net Revenue when S < K:

HK$ 4.3103 / DM * DM 4,000,000 - HK$ 260,348 = HK$ 16,980,852

Breakeven exchange rate between market hedge and put option:

(HK$ 17,414,000 + HK$ 260,348) / DM 4,000,000= HK$ 4.4186 / DM

II The advantages and disadvantages of the HK$/DM forward contract relative to the money market hedge

Value of the forward contract hedge

DM 4,000,000 * HK$ 4.3535/ DM= HK$ 17,414,000.

Value of the money market hedge

1. Borrow DM at 7.875%:

PV(DM receivables of 4 million) @July 15 = DM 4,000,000 / (1 + (0.07875 * (90/360)) = DM 3,922,770

2. Sell DM at the spot market at HK$ 4.3085/DM:

DM 3,922,770 * HK$4.3085/DM = HK$ 16,901,257

3. Invest HK$ 16,901,257 at 13.25 %:

HK$ 16,901,257 * (1 + (0.1325 * (90/360)) = HK$ 17,461,111

As the calculations above demonstrate, at the current interest rates, the money market hedge offers higher revenues (HK$ 17,461,111) than the forward contract (HK$ 17,414,000).

Additionally, each strategy may have different transaction costs that would make one strategy preferable to the other. For the forward hedge, GET is required