Module 4 Mini-Case

I knew There Had to Be a Better Way

You are now the not-so-new CFO of Agri-Drone. Its been over a year since you
introduced the Company to the idea of managing risks it confronts in doing business
overseas. The market buzz about the Companys innovation has continued. The first foreign
customer, the French farming cooperative, has made additional purchases, and word is
spreading about the Companys family of unique products.
As your first foray into the realm of international sales gathers steam, you
recommend and implement an immediate hedge of the entire $1.1 million sale to the French
Co-op by using a six month forward contract.
Youve been using that approach ever since.
As it turns out, the EUR/USD strengthens during the six months of that first forward
contract, and it sits at 1.40 at the time Agri-Drone receives its payment in euros. Jim, the
VP of Sales, isnt the only person to comment that Agri-Drone would have been better off in
hindsight without your forward contract in place.
You just shake your head.
The good news is that most members of the Companys leadership team get it. Your
initiative in protecting the Company has been recognized, and with the endorsement of
Stephanie Majors, the CEO, you have educated the leadership team about the Companys
foreign currency risks and what it should be doing about them. With the exception of Jim,
who continues to chide you when (and only when) currency fluctuations go in Agri-Drones
favor, everybody seems pretty happy.
There is one person who is truly not satisfied, however, and thats you.
This is getting expensive!
What has caused your frustration is your need to constantly commit Agri-Drones
borrowing capacity to support what seems to be an ever-growing series of forward contracts
that are, just now, starting to involve multiple currencies. Your bank, behaving like banks
do, insists on a progressively growing letter of credit to back the forward contracts. Under
your loan agreement, letters of credit get subtracted from your credit line, so your
borrowing capacity gets reduced.
You, of course, can contemplate better uses for the credit line in support of the
Companys rapid growth. Certainly, it could be used for expanded working capital needs, but
youre also starting to hear whispers of plant expansion ideas. Some of these certainly could
be outside of the U.S.
You know that sooner or later a more cost efficient way of handling Agri-Drones
currency risk issues will be needed as the types of risk evolve.
So, you begin to explore other ways to contain currency risk. Sure, you know about
options, but you think their cost would be a hard sell internally. You can almost hear Jim
saying: What? Two or three percent right off the top on every international deal? While
you hate to admit it, on this one you and Jim agree.
And so today you are wondering about two things:
1. Is there a more cost-effective way to eliminate foreign currency risk?
2. Is there truly a need to eliminate all foreign currency risk?
Continue next page.

Module 4 Mini-Case / Global Finance 2

Why didnt I think of that sooner!

This afternoon, as you struggle with your dilemma, you walk into the office kitchen
to make a cup of coffee. As youre waiting for the K-cup to brew, you see some panelists
fast-talking on CNBC TV about risk bracketing and risk arbitrage on investments in volatile
stocks. One of them shouts, Its almost free! Not catching the full drift, you grab your
coffee and walk back to your office.
And then it hits you. He was talking about option premiums being almost free,
which, of course, you know isnt the case. Option premiums always seem to be priced at a
few percent of the underlying security value, which is far from almost free. That can only
mean he was talking about offsetting option premiums.
And you sit up and gasp as a revelation hits you.
Problem 1
How could option premiums be offsetting? Explain in a narrative way.
Note: The space expands as you write.
If you buy a call with one premium amount and sell a put with the same premium amount
one revenue stream is coming in and another is going out. These amounts will offset each
other.

Now were getting somewhere!

You figure out how offsetting option premiums can be achieved, and now you turn
your attention to how to use them at Agri-Drone. Your objective is the same: protect the
Company against its foreign currency risks on major sales to foreign customers. However,
with the increased volume of activity, you seek to explore ways to eliminate something less
than 100 percent of the risk and you broach that idea to Stephanie Majors, the CEO. She
encourages you to continue your research. And so, as is your nature, you start playing with
some numbers.
Assume the following facts:
Current EUR/USD spot rate -

1.30

6 mo. forward contract pricing

-0.0100

6 mo. EUR/USD Call strike 1.3000 premium $0.035

6 mo. EUR/USD Call strike 1.3200 premium

$0.025

6 mo. EUR/USD Put strike 1.3000 premium $0.045

6 mo. EUR/USD Put strike 1.2800 premium

$0.025

Problem 2
What pairing of options would come closest to achieving the same risk management
attributes of a EUR/USD six month forward contract? Why?
Note: The space expands as you write.

Pairing the call at 1.32 and the put at 1.30 when you factor in their premiums the
net is zero. This gives up all the upside and provides total protection from any
downside risk just like a forward.

2014 Lake Forest Graduate School of Management

Module 4 Mini-Case / Global Finance 3

Finally, I may have a better answer!

Your deepening understanding of option strategies has CEO Majors quite impressed. Shes
asked for a simple demonstration, which you prepare and deliver.
Problem 3
Assuming only the fact-set presented, what strategy would you suggest to limit most of the
currency risk on a substantial sale to a European customer, while at the same time
minimizing transaction costs to the Company?
I would go with the option laid out below. They could lose .02 on the downside but they
could also gain .02 on the upside. The premiums offset each other so there is no cost for a
possible gain.

Problem 4
Assume the sale price is set at $1,000,000 and the contract specified payment of 769,231
Euros in six months upon delivery. Using your suggested strategy, prepare a calculation of
the ultimate dollar revenues received, net of option costs, assuming the six month EUR/USD
actually ends up being 1.25, 1.30 and 1.35. Also, present a side calculation of what would
occur if no mitigation strategy was used.
(see answer below).

2014 Lake Forest Graduate School of Management

Module 4 Mini-Case / Global Finance 4

2014 Lake Forest Graduate School of Management