Case Study Global Financial Management:

For October 1995 a spot rate of 87,7 JPY/USD (or 0,1141 USD/JPY) can be expected.
Derived from the non-arbitrage condition of Covered Interest Parity we can compute the
USD/JPY forward rate. We use the 6 month yearly interest rates given in the case which are
1,69% for the foreign money market (JPY) and 6,12% for the home money market (USD),
which are divided by 2 to adjust the interest rate to the 6 month time frame. By multiplying
the current spot rate (0,0112) by (1+0,0306)/(1+0,0085) we obtain the expected forward rate
as indicated in the table below. We expect that the JPY will appreciate against the USD.
direct rate indirect rate
Spot rate (USD/JPY) 0,01116 89,6
F(T) rate (USD/JPY) 0,01141 87,7

The table below shows the expected revenues in foreign currency converted into the home
currency using the expected spot rates for October 1995. The JPY exposure should be
inspected in more detail. Indeed, the JPY revenues make up 39% of our expected total
revenue and are expected to increase by 28% YoY making it by far the largest FX position.
Furthermore, the Japanese and the US Economy are less intertwined and currency fluctuations
become more likely, which leads to higher risk. The volatility estimates from Exhibit 1 show
that JPY is the second most volatile currency with 9,7% right after the Italian lira with 10,9%.
However, the exposure to Italian lira does not have to be inspected more closely since Diva
Shoes has payables to Italian suppliers which act as an operating hedge. The CAD revenues
represent 27% of revenue, however this currency shows the lowest volatility estimate with
4,4% and thus bears lower risk. The exposure to French francs is less important with only 6%
of revenues. Since the firm has high margins (i.e. gross margin of 45%) and is in a solid
financial position it can afford not to hedge all its FX risk.
USD revenues JPY revenues FRF revenues Lira revenues CAD revenues
in FC - JPY 1803519043 FRF 14010000 LIRA 7909729000 CAD 17123000
Expected rate (USD/FC) - $ 0,01141 $ 0,20000 $ 0,00062 $ 0,79365
in HC $ 9 000 000,00 $ 20 570 672,52 $ 2 802 000,00 $ 4 882 548,77 $ 13 589 682,54
as % of total revenue 18% 40% 6% 10% 27%
% change vs 9/26/1994 13% 28% -2% -6% -14%

In order to hedge the FX exposure there are two options. First, there is the possibility to enter
into a forward contract to buy dollars for a fixed amount of foreign currency. The second
possibility would be to buy put options on JPY.
In the table below we can identify the USD pay-offs in the different scenarios. The forward
hedge pay-off was computed by multiplying the expected JPY amount by the direct forward
rate. For the option hedge pay-off we first computed the pay-off in the three different
scenarios comparing the exercise of the option with the pay-off without exercising the option.
Then we subtracted the option premium (0,0003 multiplied by the expected JPY revenue)
from the higher of the two previously calculated values.
We can see that in Scenario 1 and 2 it would be best to use the forward hedging option
since the forward hedge pay-off is higher. In contrast, in Scenario 3 the put option hedging
alternative leads to a significantly higher pay-off. We can see that with put options we limit
or downward potential by keeping the upward potential associated with currency fluctuations.
Since Diva Shoes Inc. is in a solid financial position, which enables the company to bear a
limited and calculated downward risk we recommend hedging the FX exposure buying put
options on JPY, since in this case we can take advantage of significant upward potential.
Forward hedge pay-off Option hedge pay-off Option premium Option is exercised Option is not exercised
Scenario 1 $ 20 541 219,17 $ 19 953 478,87 $ 541 055,71 $ 20 494 534,58 $ 20 039 100,48
Scenario 2 $ 20 541 219,17 $ 20 430 095,95 $ 541 055,71 $ 20 494 534,58 $ 20 971 151,66
Scenario 3 $ 20 541 219,17 $ 21 188 089,38 $ 541 055,71 $ 20 494 534,58 $ 21 729 145,10