Question 1

Problem

Baldwin Enterprises is a large manufacturing company with operations and sales divisions
located in the United States and several other countries. The CFO of the organization, Wes
Hamrick, is concerned about the amount of money Baldwin has been paying in transaction costs
in the foreign exchange markets and has asked you to help optimize Baldwin’s foreign exchange
treasury functions. With operations in several countries, Baldwin maintains cash assets in several
different currencies: U.S. dollars (USD), the European Union’s euro (EUR), Great Britain’s
pound (GBP), Hong Kong dollars (HKD), and Japanese yen (JPY). To meet the different cash-
flow requirements associated with the company’s operations around the world, Baldwin must
often move funds from one location (and currency) to another. For in- stance, to pay an
unexpected maintenance expense at the company’s facility in Japan, Baldwin may need to

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convert some of its holdings in U.S. dollars to Japanese yen. The foreign exchange (FX) market

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is a network of financial institutions and brokers in which individuals, businesses, banks, and

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governments buy and sell the currencies of different countries. They do so in order to finance

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international trade, invest or do business abroad, or speculate on currency price changes. The FX

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market operates 24 hours a day and represents the largest and most liquid marketplace in the
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global economy. On average, the equivalent of about $1.5 trillion in different currencies is traded
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daily in the FX market around the world. The liquidity of the market provides businesses with
access to international markets for goods and ser- vices by providing the foreign currency
necessary for transactions worldwide (see http://www.ny.frb.org/fxc).
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The FX market operates in much the same way as a stock or commodity market where there is a
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bid price and ask price for each commodity (or, in this case, currency). A bid price is the price at
which the market is willing to buy a particular currency, and the ask price is the price at which
the market is willing to sell a currency. The ask prices are typically slightly higher than the bid
prices for the same currency— representing the transaction cost or the profit earned by the
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organizations that keep the market liquid.

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The following table summarizes the current FX rates for the currencies Baldwin currently holds.
The entries in this table represent the conversion rates from the row currencies to the column
currencies.
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Convert/To USD EUR GBP HKD JPY

USD 1 1.01864 0.6409 7.7985 118.55
EUR 0.9724 1 0.6295 7.6552 116.41
GBP 1.5593 1.5881 1 12.154 184.97
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HKD 0.12812 0.1304 0.0821 1 15.1005

JPY 0.00843 0.00856 0.0054 0.0658 1

For example, the table indicates that 1 British pound (GBP) can be exchanged (or sold) for
1.5593 U.S. dollars (USD). Thus, $1.5593 is the bid price, in U.S. dollars, for 1 British pound.

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 Alternatively, the table indicates 1 U.S. dollar (USD) can be exchanged (sold) for 0.6409 British
pounds (GBP). So, it takes about 1.5603 U.S. dollars (or 1/0.6409) to buy 1 British pound (or the
ask price, in U.S. dollars, for 1 British pound is roughly $1.5603).

Notice that if you took 1 British pound, converted it to 1.5593 U.S. dollars, and then converted
those 1.5593 dollars back to British pounds, you would end up with only 0.999355 British
pounds (that is, 1 X 1.5593 X 0.6409 = 0.999355). The money you lose in this exchange is the
transaction cost.

Baldwin’s current portfolio of cash holdings includes 2 million USD, 5 million EUR, 1 million
GBP, 3 million HKD, and 30 million JPY. This portfolio is equivalent to $9,058,560 USD under
the current exchange rates (given earlier). Wes has asked you to design a currency-trading plan
that would increase Baldwin’s euro and yen holdings to 8 million EUR and 54 JPY, respectively,
while maintaining the equivalent of at least $250,000 USD in each currency. Baldwin measures
transaction costs as the change in the USD equivalent value of the portfolio.

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1. Create a spreadsheet model for this problem and solve it.
2. What is the optimal trading plan?

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3. What is the optimal transaction cost (in equivalent USD)?
4. Suppose another executive thinks that holding $250,000 USD in each currency is

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excessive and wants to lower the amount to $50,000 USD in each currency. Does this
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help to lower the transaction cost? Why or why not?
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5. Suppose the exchange rate for converting USD to GBP increased from 0.6409 to
0.6414. What happens to the optimal solution in this case?
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Conclusion

The optimal trading plan is to sell 2.945million USD for EUR, 0.84million GBP for JPY,
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9.328million HKD for USD and 131.314million JPY for HKD. The optimal transaction cost is
0.0279million USD.
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Lowering the amount to $50,000 USD in each currency helps to lower the transaction cost from
0.0278668million USD to 0.0278602 million USD.
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The objective cell values do not converge. Therefore, we can use arbitrage trading (USD to GBP,
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GBP to USD) to make infinite money.

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 1. Create a spreadsheet model for this problem and solve it.
2. What is the optimal trading plan?
3. What is the optimal transaction cost (in equivalent USD)?

Managerial Problem Definition

We want to minimize the transaction costs, subject to the amount of each currency, the
conversion rates between each currency, and the difference between currencies before and after
transaction.

Decision Variables
Baldwin Enterprises needs to decide how much they should trade for each currency.

Objective
Baldwin Enterprises needs to minimize the total transaction costs.

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Constraints

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The currency-trading plan should include 8 million EUR and 54 JPY, while maintaining the

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equivalent of at least $250,000 USD in each currency.

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Mathematical Formulation rs e
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Decision Variables
X12: amount of USD in exchange for EUR
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X13: amount of USD in exchange for GBP

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X14: amount of USD in exchange for HKD

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X15: amount of USD in exchange for JPY

X21: amount of EUR in exchange for USD
X23: amount of EUR in exchange for GBP
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X24: amount of EUR in exchange for HKD

X25: amount of EUR in exchange for JPY
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X31: amount of GBP in exchange for USD

X32: amount of GBP in exchange for EUR
X34: amount of GBP in exchange for HKD
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X35: amount of GBP in exchange for JPY

X41: amount of HKD in exchange for USD
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X42: amount of HKD in exchange for EUR

X43: amount of HKD in exchange for GBP
X45: amount of HKD in exchange for JPY
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X51: amount of JPY in exchange for USD

X52: amount of JPY in exchange for EUR
X53: amount of JPY in exchange for GBP
X54: amount of JPY in exchange for HKD

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 Objective
Minimize the change in the USD equivalent value of the portfolio.

Minimize 9.05856 – [Y11 * (2 + X21 Y21 + X31 Y31 + X41 Y41 + X51 Y51 – (X12 + X13 + X14 +X15)) + Y21 *
(5 + X12 Y12 + X32 Y32 + X42 Y42 + X52 Y52 – (X21 + X23 + X24 + X25)) + Y31 * (1 + X13 Y13 + X23 Y23 + X43
Y43 + X53 Y53 – (X31 + X32 + X34 + X35)) + Y41 * (3 + X14 Y14 + X24 Y24 + X34 Y34 + X54 Y54 – (X41 + X42 +
X43 + X45)) + Y51 * (30 + X15 Y15 + X25 Y25 + X35 Y35 + X45 Y45 – (X51 + X52 + X53 + X54)) ]

(Xij : the amount of currency exchange ; 1<=i<=5, 1<=j<=5; 1-USD, 2-EUR, 3-GBP, 4-HKD, 5-
JPY
Yij: the exchange rates between i and j; 1<=i<=5, 1<=j<=5; 1-USD, 2-EUR, 3-GBP, 4-HKD, 5-
JPY)

Constraints
X12, X13, X14, X15, X21, X23, X24, X25, X31, X32, X34, X35, X41, X42, X43, X45, X51, X52, X53, X54 ≥ 0
2 + X21 Y21 + X31 Y31 + X41 Y41 + X51 Y51 – (X12 + X13 + X14 +X15) ≥ 0

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5 + X12 Y12 + X32 Y32 + X42 Y42 + X52 Y52 – (X21 + X23 + X24 + X25) ≥ 8
1 + X13 Y13 + X23 Y23 + X43 Y43 + X53 Y53 – (X31 + X32 + X34 + X35) ≥ 0

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3 + X14 Y14 + X24 Y24 + X34 Y34 + X54 Y54 – (X41 + X42 + X43 + X45) ≥ 0
30 + X15 Y15 + X25 Y25 + X35 Y35 + X45 Y45 – (X51 + X52 + X53 + X54) ≥ 54

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Y11 * (2 + X21 Y21 + X31 Y31 + X41 Y41 + X51 Y51 – (X12 + X13 + X14 +X15)) ≥ 0.25
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Y21 * (5 + X12 Y12 + X32 Y32 + X42 Y42 + X52 Y52 – (X21 + X23 + X24 + X25)) ≥ 0.25
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Y31 * (1 + X13 Y13 + X23 Y23 + X43 Y43 + X53 Y53 – (X31 + X32 + X34 + X35)) ≥ 0.25
Y41 * (3 + X14 Y14 + X24 Y24 + X34 Y34 + X54 Y54 – (X41 + X42 + X43 + X45))≥ 0.25
Y51 * (30 + X15 Y15 + X25 Y25 + X35 Y35 + X45 Y45 – (X51 + X52 + X53 + X54)) ≥ 0.25
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Sell : X12 + X13 + X14 +X15

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X21 + X23 + X24 + X25

X31 + X32 + X34 + X35
X41 + X42 + X43 + X45
X51 + X52 + X53 + X54
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Buy: X21 Y21 + X31 Y31 + X41 Y41 + X51 Y51

X12 Y12 + X32 Y32 + X42 Y42 + X52 Y52
X13 Y13 + X23 Y23 + X43 Y43 + X53 Y53
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X14 Y14 + X24 Y24 + X34 Y34 + X54 Y54

X15 Y15 + X25 Y25 + X35 Y35 + X45 Y45
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Ending:
2 + X21 Y21 + X31 Y31 + X41 Y41 + X51 Y51 – (X12 + X13 + X14 +X15)
5 + X12 Y12 + X32 Y32 + X42 Y42 + X52 Y52 – (X21 + X23 + X24 + X25)
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1 + X13 Y13 + X23 Y23 + X43 Y43 + X53 Y53 – (X31 + X32 + X34 + X35)
3 + X14 Y14 + X24 Y24 + X34 Y34 + X54 Y54 – (X41 + X42 + X43 + X45)
30 + X15 Y15 + X25 Y25 + X35 Y35 + X45 Y45 – (X51 + X52 + X53 + X54)

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 Solution Methodology

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The optimal trading plan is to sell 2.945million USD for EUR, 0.84million GBP for JPY,
9.328million HKD for USD and 131.314million JPY for HKD. The optimal transaction cost is
0.0278668million USD.
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4. Suppose another executive thinks that holding $250,000 USD in each currency is
excessive and wants to lower the amount to $50,000 USD in each currency. Does this help to
lower the transaction cost? Why or why not?
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It helps to lower the transaction cost from 0.0278668million USD to 0.0278602million USD.

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 5. Suppose the exchange rate for converting USD to GBP increased from 0.6409 to 0.6414.
What happens to the optimal solution in this case?

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The objective cell values do not converge. Therefore, we can use arbitrage trading (USD to GBP,
GBP to USD) to make infinite money.
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 Sensitivity Report:

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Reduced Cost
The reduced costs tell us how much the objective coefficients (unit profits) can be increased or
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decreased before the optimal solution changes.

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Shadow Price
The shadow prices tell us how much the optimal solution can be increased or decreased if we
change the right hand side values (the constraints) with one unit.
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The allowable increase on a constraint RHS is the maximum amount the RHS can increase
without the dual price changing.

The allowable decrease on a constraint RHS is the maximum amount the RHS can decrease
without the dual price changing.

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