Casasophia Co

(6/11, amended)
 Casasophia Co
Casasophia Co, based in a European country that uses the
Euro (€), constructs and maintains advanced energy
efficient commercial properties around the world. It has
just completed a major project in the US and is due to
receive the final payment of US$20 million in four
months.
 Casasophia Co
Casasophia Co is planning to commence a major
construction and maintenance project in Mazabia, a small
African country, in six months' time. This government-
owned project is expected to last for three years during
which time Casasophia Co will complete the construction
of state-of-the-art energy efficient properties and provide
training to a local Mazabian company in maintaining the
properties. The carbon-neutral status of the building
project has attracted some grant funding from the
European Union and these funds will be provided to the
Mazabian Government in Mazabian Shillings (MShs).
 Casasophia Co
Casasophia Co intends to finance the project using
the US$20 million it is due to receive and borrow the
rest through a € loan. It is intended that the US$
receipts will be converted into € and invested in
short-dated treasury bills until they are required.
These funds plus the loan will be converted into
MShs on the date required, at the spot rate at that
time.
 Casasophia Co
Mazabia's Government requires Casasophia Co to
deposit the MShs2.64 billion it needs for the project,
with Mazabia's central bank, at the commencement of
the project. In return, Casasophia Co will receive a
fixed sum of MShs1.5 billion after tax, at the end of
each year for a period of three years. Neither of these
amounts is subject to inflationary increases. The
relevant risk adjusted discount rate for the project is
assumed to be 12%.
Casasophia Co
Financial information
Exchange rates available to Casasophia
Per €1 Per €1
Spot US$1.3585–US$1.3618 MShs116–MShs128
4-month forward US$1.3588–US$1.3623 Not available

Currency futures (Contract size €125,000, Quotation: US$ per €1)

2-month expiry 1.3633
5-month expiry 1.3698
Casasophia Co
Currency options (Contract size €125,000, Exercise price quotation: US$ per €1,
cents per Euro)
Calls Puts
Exercise price 2-month expiry 5-month expiry 2-month expiry 5-month expiry
1.36 2.35 2.80 2.47 2.98
1.38 1.88 2.23 4.23 4.64

Casasophia Co Local Government Base Rate 2.20%

Mazabia Government Base Rate 10.80%
Yield on short-dated Euro Treasury Bills 1.80%
(assume 360-day year)
 Casasophia Co
Mazabia's current annual inflation rate is 9.7% and is expected
to remain at this level for the next six months. However, after
that, there is considerable uncertainty about the future and the
annual level of inflation could be anywhere between 5% and
15% for the next few years. The country where Casasophia Co
is based is expected to have a stable level of inflation at 1.2%
per year for the foreseeable future. A local bank in Mazabia has
offered Casasophia Co the opportunity to swap the annual
income of MShs1.5 billion receivable in each of the next three
years for Euros, at the estimated annual MShs/€ forward rates
based on the current government base rates.
 Casasophia Co
Required
a) Advise Casasophia Co on, and recommend, an appropriate
hedging strategy for the US$ income it is due to receive in
four months. Include all relevant calculations. (15 marks)

b) Given that Casasophia Co agrees to the local bank's offer

of the swap, calculate the net present value of the project,
in six months' time, in €. Discuss whether the swap would
be beneficial to Casasophia Co.
(10 marks)
(Total = 25 marks)
 Casasophia Co - Answer
(a) Hedging strategy
Forward contract
The company will be receiving US$ therefore we use US$1.3623 as the rate.
Receipt in € = US$20m/1.3623 = €14,681,054
The hedge fixes the rate at €1 = US$1.3623. This rate is legally binding.
Futures contract
A 2 month contract is too short for the required hedge period therefore we must Buy
5 month contract.
The contract will be closed out in four months' time.
 Casasophia Co - Answer
You can estimate the futures rate using the 5 month price, the spot rate and the
four-month forward rate:
We could estimate the number of contracts needed as:
$'000 €'000 Contract size No contracts
20,000 1.3698 14,601 125 117
Outcome
The outcome will depend on the spot and future prices, the futures price can be
estimated as follows:
Now 4 months
5 month future 1.3698 1.3714 balance
Spot rate 1.3618 1.3698 assumed
Basis 0.0080 × 1/5 = 0.0016
5 months 1 month remaining
 Casasophia Co - Answer
Assuming that the spot rate in 4 months is the same as the futures rate, the
outcome will be:
$'000 €'000
Actual $20,000
Assumed spot in 4 months 1.3698 (alternative
assumptions are possible)
In euros (000s) € 14,601
Future
Opening 1.3698 to buy
Closing 1.3714 to sell
Ticks (0.0016)
Profit (000) €17
(117 × 125,000 × 0.0016 / spot 1.3698)
€ 14,618
Effective rate (20,000/14,618) 1.3682
 Casasophia Co - Answer
Alternative short-cut approach
Opening future rate – closing basis = 1.3698 – 0.0016 = effective rate 1.3682
 Casasophia Co - Answer
Comments
The futures rate is worse than the forward rate. Futures contracts are
marked to market on a daily basis and require margin payments as a
result. As with forward contracts, futures contracts fix the rates and
are legally binding.

Options
With options the holder has the right but not the obligation to
exercise the option (that is, the option will be exercised if it is
beneficial to the holder). However there is a premium to be paid for
this flexibility, making options more expensive than futures and
forward contracts.
 Casasophia Co - Answer
To protect itself against a weakening US$, Casasophia will purchase Euro
call options.
Exercise price = $1.36
Receipts = $20m/1.36 = €14,705,882
Number of contracts = €14,705,882/€125,000 = 117.6 contracts (117
contracts)
With 117 contracts, receipts = €125,000 × 117 = €14,625,000
Premium payable = $0.0280 × 117 × 125,000 = $409,500 (or
$409,500/1.3585 = €301,435)
Amount not hedged = US$20m – (117 × €125,000 × 1.36) = US$110,000
 Casasophia Co - Answer
This amount can be hedged using a 4 month forward contract as follows:
US$110,000/1.3623 = €80,746
Total receipts = €14,625,000 – €301,435 + €80,746 = €14,404,311
Exercise price = $1.38
Receipts = $20m/1.38 = €14,492,754
Number of contracts = €14,492,754/€125,000 = 115.9 contracts (purchase
115 contracts)
With 115 contracts, receipts = €125,000 × 115 = €14,375,000
Premium payable = $0.0223 × 115 × 125,000 = US$320,563 (or
$320,563/1.3585 = €235,968)
Amount not hedged = US$20m – (115 × €125,000 × 1.38) = US$162,500
 Casasophia Co - Answer
This amount can be hedged using a 4 month forward contract as follows:
US$162,500/1.3623 = €119,284
Total receipts = €14,375,000 – €235,968 + €119,284 = €14,258,316
The receipts from either of the options are considerably lower than those
from either the futures contract or the forward contract. This is primarily
due to the premiums payable to secure the flexibility that options offer.
The US$ would have to move significantly against the € to allow
Casasophia to cover the cost of the premiums.
 Casasophia Co - Answer
Conclusion
Based on the calculations above, it is recommended that
Casasophia uses forward contracts to hedge against the US$
depreciating against the € in order to maximise receipts.
The company should be aware that once the contract is agreed,
the price is fixed and is legally binding. In addition there is no
formal exchange for forward contracts, thus giving rise to default
risk.
 Casasophia Co - Answer
(b) Project NPV
Expected forward rates (using interest rate parity)

Year Forward rate (€1 = MShs)

Half year 128 × (1.108/1.022) = 138.77
128 + [(138.77 – 128)/2] = 133.38
1.5 years 133.38 × (1.108/1.022) = 144.60
2.5 years 144.60 × (1.108/1.022) = 156.77
3.5 years 156.77 × (1.108/1.022) = 169.96
 Casasophia Co - Answer
NPV calculation (note that year 1 actually means 1.5 years from now as
project starts in 6 months' time)

Year 1 2 3
Income (MShs, million) 1,500 1,500 1,500
Forward rate 144.60 156.77 169.96
Income (€m) 10.37 9.57 8.82
Discount factor (12%) 0.893 0.797 0.712
DCF 9.26 7.63 6.28

Total Present Value = €23.17m

 Casasophia Co - Answer
Expected spot rate (MShs) in 12 months' time (using Purchasing Power
Parity):

S1 = 116 × (1 + 0.097)/(1 + 0.012) = 125.74

In 6 months' time expected spot rate = 116 + (125.74 – 116)/2 = 120.9
Total investment required in € = MShs2.64 billion/120.9 = €21.84m

NPV = €1.33m
 Casasophia Co - Answer
Will the swap be beneficial for Casasophia?
Forward rates based on interest rate parity show that MShs is
depreciating against the € as interest rates are much higher in
Mazabia (10.8%) than in the European country (2.2%). However
even with a depreciating MShs the project is still worthwhile
(positive NPV).
When forward rates are estimated using purchasing power parity, it
is assumed that forward rates will change according to differences
between the two countries' inflation rates. If Mazabia's inflation rate
is greater than the European country's rate, the MShs will depreciate
against the €.
 Casasophia Co - Answer
We are told that Mazabia's inflation rate could vary between 5%
and 15% over the next few years therefore a swap would appear
to be advantageous (as it would fix the future exchange rates).
Without the swap there will be uncertainty over the NPV of the
project.
Default risk should also be taken into consideration and
Casasophia may ask the government of Mazabia to act as a
guarantor in order to reduce the risk.
The grant funding will currently be provided directly to the
Mazabian government in MShs. It may be worthwhile for
Casasophia to explore the possibility of receiving the grant
directly in € as this would reduce currency exposure.
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