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TB0197
November 1, 1998

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TCAS, Inc.

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On May 16, 1995, Mr. John Christopher, the assistant treasurer of TCAS, Inc., pondered
several foreign exchange hedging alternatives that had been outlined by the account man-
ager from his lead bank. Mr. Christopher had called his account manager, Judy Wright, to
ask for her advice regarding a Canadian dollar contract Mr. Christopher had negotiated
with a Canadian company. Ms. Wright, after first evaluating macroeconomic fundamentals
and determining what her bank’s lending rates were likely to be based on this outlook, was

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now ready to advise Mr. Christopher of the various alternatives to hedge the foreign cur-
rency risk.

Company Background
TCAS (Transnational Corporate Advisory Services), Inc. was founded in 1982 as a finan-
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cial training and consulting firm incorporated in Delaware. Its primary assets and products
were the knowledge and skills of the three founding partners. All three had worked for the
Continental Illinois National Bank for about twelve years but left the bank before its prob-
lems in 1984. The expertise of the three founders was multinational business management
including the financial, production, and marketing aspects of doing business globally.
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In 1988, TCAS merged with Computer Software and Systems Company to extend its
products to include management information systems. TCAS, Inc. was involved in devel-
oping specialized software and building custom-designed, local area personal computer
networks for small- and medium-sized companies. Because of the dramatic changes in com-
puter technology and communication during the decade of the 1980s, the deregulation of
financial markets, and the increased emphasis on globalization, TCAS, Inc. experienced
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rapid growth in net income and assets. However, beginning in 1993, TCAS began to face
sharply increased competition from much larger corporations that began to sell very com-
petitively priced services. As a result of these developments, TCAS’s net income narrowed
dramatically in 1993 and 1994. The company was heavily in debt and had only a few
contracts in hand. TCAS was headquartered in Phoenix, Arizona, and its customer base to
date had been comprised totally of US companies. TCAS decided that it was time to “go
international.”
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John Christopher recognized that the submission of the bid in Canadian dollars to a
Canadian customer was fundamentally a risky step for TCAS. He also realized that, in
Copyright © 1998, 1996 Thunderbird, The American Graduate School of International Management. All rights re-
served. This case was prepared by F. John Mathis and James L. Mills for the purpose of classroom discussion only, and not
to indicate either effective or ineffective management.

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order to survive, the company had to expand its traditional customer base. John Christo-
pher was surprised when TCAS was awarded the bid. He knew that his foreign exchange

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worries had just begun and he was in need of expert help.

EXHIBIT 1 TCAS, Inc.

Sales and Income Statement

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Year Ended Sales Net Income
Dec. 31 (US$ 000) (US$ 000)
1987 1250.0 550.0
1988 1930.0 850.0
1989 2200.0 1120.0
1990 2270.0 1050.0
1991 2940.0 1640.0
1992 3150.0 1700.0

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1993 2870.0 550.0
1994 2650.0 -250.0

1994 Balance Sheet

ASSETS
Current assets: (US$ 000)
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Cash and securities 250.0
Accounts receivable 620.0
Inventories 80.0
Total current assets 950.0
Property, plant and equipment
Cost 2240.0
less Accumulated depreciation (330.0)
Goodwill and intangibles 520.0
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TOTAL ASSETS 3380.0

LIABILITIES
Current liabilities
Bank loans 810.0
Accounts payable 480.0
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Notes payable 120.0

Long-term liabilities
Debt 620.0

TOTAL LIABILITIES 2030.0

Equity and retained earnings 1350.0

TOTAL LIABILITIES AND EQUITY 3380.0

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The Bid
TCAS had bid Canadian dollar C$2,900,00 for the delivery and the installation of a new
management information software system and an extensive local area network (LAN) com-
puter system. The bid had been put together by the accounting department and accurately

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reflected costs. The bid was tendered on March 21 by FAX and was accepted on May 15. In
accordance with the terms of the contract, the Canadian government agency (Canadian

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Crown Corporation) had telexed a letter of acceptance of the bid and wired 10% of the
purchase price as a deposit on the morning of May 16. Also under the terms of the contract,
TCAS would have to secure a performance bond from a third-party vender if awarded the
bid. The performance bond would cost .75% of the outstanding contract value.

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The remainder of the purchase price was due at the time the system was to be delivered
and installed, which under the terms of the contract was to be within 90 days (the Cana-
dian company had insisted on the 90 days and TCAS needed the extra time over the normal
45-day credit period) after the bid was accepted. The TCAS production manager had as-
sured Mr. Christopher that there would be no problems in meeting this delivery schedule
for the hardware, although the product was not currently in inventory. The software was
already developed and available. Consequently, Mr. Christopher expected to receive a certi-

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fied check for C$2,610,000 on August 16.

In preparing the bid, TCAS allowed for a tight mark-up of only 5% (see Exhibit 2) to
improve the chances of winning the bid. Through past experience, TCAS knew that once it
made the first sale, the quality of its product usually ensured additional purchases by the
same company. Since the Canadian government agency had stipulated that the bid be in
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Canadian dollars, TCAS had used the opening spot rate existing on March 21, which was
1US$ = Canadian $1.4096.

EXHIBIT 2 Bid Preparation (US$)

Design 300,000
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Materials 779,287
Labor & installation 724,500
Shipping 32,466
Direct overhead 84,000
Allocation of indirect overhead 39,100
Sub-total 1,959,353
Mark-up (5%) 97,967
TOTAL BID US$ 2,057,320
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Conversion to C$ at March 21 spot rate of 1US$ = Canadian $1.4096 C$2,900,000

The US Dollar and the Canadian Dollar

On May 16, 1995, the day after the bid was accepted, the value of the US dollar closed at
1US$ = C$1.3594. The Canadian$/US$ exchange rate had moved erratically within a rela-
tively narrow range over the past several months as reflected in the following table:
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Month Avg. C$/1US$

January 3 1.4027
February 7 1.3978
March 7 1.4168
April 4 1.4005
May 2 1.3553
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The Canadian dollar had remained relatively stable against the US$ until mid-April
1995. It declined to the low registered on May 2 and recovered slightly by mid-May. Mr.

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Christopher was concerned that the Canadian dollar might depreciate against the US$
during the next 90 days before he received his final payment from the Canadian govern-
ment agency. Mr. Christopher wanted to know what alternatives were available to him to
reduce the foreign exchange risk associated with the outstanding Canadian dollar contract.

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Foreign Currency Exposure Management
Judy Wright explained to Mr. Christopher the alternatives available to manage the foreign
exchange risk brought about by the Canadian dollar contract. First, Mr. Christopher could
do nothing. Over the 55 days since the bid was tendered, the US$ had depreciated by
Canadian $0.0502 from Canadian dollar 1.4096 to Canadian dollar 1.3594, or 3.6% in
absolute terms. This exchange rate change, if it held steady for the 90 days, would improve

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TCAS’s mark-up from 5% to 8.6% when the Canadian dollars were converted into US
dollars. Further depreciation of the US dollar could not be ensured, Judy explained, based
on her review of macroeconomic fundamentals.

Foreign Currency Exposure Management Alternatives

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The evaluation of expected macroeconomic developments confirmed Mr. Christopher’s
concerns about a possible depreciation of the Canadian dollar. Ms. Wright explained that a
foreign currency hedge would be an appropriate response to the foreign exchange risk faced
by TCAS, Inc. Since TCAS had an outstanding Canadian dollar contract, a hedge could be
accomplished by any one of the following techniques:
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1. Forward contract—This involved arranging to deliver Canadian $2,610,000 90 days in

the future for conversion into US$ at a predetermined exchange rate. Thus, Mr. Chris-
topher could contract today with Ms. Wright to deliver the Canadian dollar converted
at today’s quoted three-month forward rate of 1US$ = Canadian $1.3653.

2. Foreign currency loan—This created a Canadian $ obligation 90 days hence. TCAS

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could borrow Canadian $ from Ms. Wright’s bank for 90 days and then use the pro-
ceeds on completion of the contract to repay the principal and accrued interest. The
loan proceeds would be converted immediately into US$ at the prevailing spot rate of
exchange. Any gains or losses on the receivable due to a change in the value of the
Canadian $/US$ exchange rate would be offset by equivalent losses or gains on the loan
itself. Ms. Wright thought that such a loan could be made at 2.25% above the present
Canadian prime rate of 10.25% plus an arrangement fee of 0.125%. The US prime rate
was at 8.875%. TCAS paid a spread of 2.125% over prime in the US market and would
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pay a similar spread in Canada

3. Foreign currency options—This instrument would give TCAS the right to either pur-
chase (call) or sell (put) an asset at a specified price at a date in the future (European
style) or anytime between the purchase date and a date in the future (American style).
The buyer of an option has the right but not the obligation to exercise the option. The

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buyer of an option has a choice whether to exercise the option and either receive the
asset (call) or deliver the asset (put ) or to allow the option to expire unexercised. The

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seller (writer) of the option must stand ready to fulfill an option obligation and surren-
der an asset on demand (call ) or receive an asset on demand (put). Since TCAS had a
Canadian dollar contract, it could hedge this foreign currency exposure by buying a
Canadian dollar put or writing a Canadian dollar call. Buying a Canadian dollar put
option would protect TCAS from an unfavorable downward movement in the Cana-

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dian dollar exchange rate while allowing the company to benefit from any further ap-
preciation in the Canadian dollar . The purchase of a currency option would require
that Mr. Christopher pay Ms. Wright an option premium at the time the contract was
entered into. At the time, the 90-day currency options premium rates on a strike of 1
Canadian dollar = US$ .7200 (or implied 1USdollar = Canadian dollar 1.3888) were:
call premium—US dollar 0.0356/Canadian dollar; put premium = US dollar 0.0225/
Canadian dollar. Note that the options are quoted as the US dollar price of one Cana-

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dian dollar which is the reciprocal of the Canadian dollar price of one US dollar. Writ-
ing a Canadian dollar call option would allow TCAS to benefit if there was little or no
change in the value of the Canadian dollar. Instead of paying a premium, TCAS would
receive the premium.

4. Foreign currency futures—A standardized obligation to purchase or sell a specific amount

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of currency at a specified date. The buyer or seller of the contract is obliged to take
delivery or make delivery of the currency; the position could only be eliminated if the
futures position was offset. Most futures positions are offset prior to the last day of
trading, leaving the seller with a profit or loss. Ms. Wright explained that a futures
contract could be arranged through the International Monetary Market (IMM) of the
Chicago Mercantile Exchange. The August futures price was 1C = US$ 0.735. The cost
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of a round turn per contract (the purchase and subsequent sale of a futures contract)
was US$ 50.00. Each Canadian dollar future contract represents Canadian $100,000.

5. Pre-sale of foreign contract—Ms. Wright explained that her bank had an export finance
subsidiary that would purchase the short-term Canadian dollar contract from TCAS at
a discount. The interest rate applicable was fixed for the term involved—90 days—at
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the cost of funding to the Export Finance Subsidiary, which was LIBOR currently at
7.375%, plus a premium based on normal credit criteria. At this time the credit spread
for TCAS was 1.825% over LIBOR. TCAS would incur a flat up-front fee of 0.5%. The
US dollar 90-day libor rate was 6.125%.

6. Tunnel forwards—A contractual agreement between the two parties which designates a
specific exchange rate band within which TCAS would have to exchange currencies on
a specific future date. It works like a forward exchange contract that fully protects the
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downside with no up-front premium paid, but the settlement rate falls within a range
instead of at a specific rate. The upper and lower limits of the range act as contract
settlement rates if the exchange rate exceed the limits of the range of the tunnel. Ms.
Wright indicated that at the present time a zero cost tunnel or range forward (where the
premium paid on the put is equal to the premium received) could be created with the

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strike on the Canadian dollar put set at US dollar .7133 and the strike on the Canadian
dollar call set at US$ .7533.

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Canadadian Economic Performance
After finally gaining momentum in 1994, the economic recovery faltered in early 1995.
After growing by more than 5-1/2% in 1994, real GDP increased only moderately in the

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first quarter of 1995 and was expected to decline in the second quarter, before rebounding
in the third quarter of 1995. The economic slowdown in the United States dampened the
demand for Canadian exports and the tighter monetary conditions moderated domestic
demand in Canada. Fortunately, the economic slowdown also resulted in a significant drop
in Canadian imports. The short-term interest spreads between Canada and the United
States had increased from virtually zero in November 1994 to 2% in early April 1995.
However, all indications were that the Canadian Central Bank would soon reverse policy

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direction and push interest rates lower in order to stimulate employment.

In its February 1995 budget, the federal government in Ottawa, Canada adopted dras-
tic expenditure restraint in order to convince financial markets that deficit reduction targets
would be met in spite of higher-than-expected hikes in short-term interest rates. The bud-
get included proposals for major cuts in government employment, subsidies to business
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and agriculture, and transfers to the provinces.

The most interest-sensitive components of the domestic economy, durable goods and
construction, declined markedly in the first quarter of 1995. The recent run-up in interest
rates aborted the revival of residential investment. The impact of this weakening of final
demand on the Canadian GDP was offset somewhat by a substantial accumulation of in-
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ventories.

The Canadian unemployment rate remained broadly stable in the 9-1/2% range. Per-
sistent labor-market slack kept wage increases low, and unit labor costs hardly rose. Slower
output growth has been associated with smaller productivity gains. Overall, the rate of
inflation had begun to ease.
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The Banker’s Role

Judy Wright knew that she would need to assist John Christopher in the selection of the
appropriate hedging alternative. She also knew that she should be able to talk intelligently
about the likely movements in the Canadian dollar over the next three months. Judy Wright
asked her bank’s economic department to pull together a set of numbers that would help
her explain the outlook for the Canadian dollar to Mr. Christopher.
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What economic and financial data would she request from the economic department?
What analytical framework would she use to interpret the data? How should she best ex-
plain the economic data to Mr. Christopher, and what would be her recommendation for
the appropriate hedging strategy?

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EXHIBIT 3 Marcoeconomic Data

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1989 1990 1991 1992 1993 1994 1995 Est
Real GDP Growth % Canada 2.4 -.2 -1.8 .8 2.2 4.6 2.4
Real GDP Growth % US 2.5 1.2 -.6 2.3 3.1 4.1 3.3
Inflation CPI % Canada 5.0 4.8 5.6 1.5 1.8 .2 1.9
Inflation CPI % US 4.8 5.4 4.2 3.0 3.0 2.6 2.8

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Unemployment Rate % Canada 7.5 8.1 10.4 11.3 11.2 10.4 9.6
Unemployment Rate % US 5.3 5.5 6.7 7.4 6.8 6.1 5.6
Gov. Deficit as % GDP Canada 1.4 0.7 -2.0 -2.9 -2.6 -0.5 1.0
Current Account as % of GDP Canada -3.9 -3.4 -3.7 -3.6 -3.9 -2.7 -0.5
Gross Savings as % of GDP Canada 19.4 16.4 14.3 13.2 13.7 15.4
Investment as % of GDP Canada 21.9 19.1 20.0 19.7 20.2 18.6
Current Account C$ dollar (billions) -22.8 -21.6 -23.6 -21.4 -22.3 -16.3 -10.1
Capital Account C$ (billions) 24.1 23.2 22.1 16.8 22.9 12.3 9.9

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Short-term Interest Rates Canada 12.2 13.0 9.0 6.7 5.0 5.4 7.1
Short-term Interest Rates US 8.1 7.5 5.4 3.4 3.0 4.2 5.5
Long-term Interest Rates Canada 9.9 10.8 9.8 8.8 7.9 8.6 8.3
Long-term Interest Rates US 8.5 8.6 7.9 7.0 5.9 7.1 6.6
C$/US$ Exchange Rate 1.184 1.167 1.146 1.209 1.290 1.366 1.370
Gov. Deficit as % GDP US -1.5 -2.5 -3.2 -4.3 -3.4 -2.0 -1.6

Source: OECD Economic Outlook (June 1998).

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