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Hedging Risks

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Essay title: Hedging Risks

Case 3 Hintz-Kessels-Kohl A.G.

If we assume that the $/As rate does not change the Costa Rica contract is made to appear not very attractive. The trend in the US dollar has been such that it has been appreciating. If the dollar continues its climb then revenues received in US dollars will increase.

In the case of a depreciating dollar, this would obviously make the Costa Rican contract even less appealing. If the US dollar depreciates year on year then the revenues will be less if we convert it back to Schilling.

At this stage given the rising value of the dollar, hedging would in fact make HKK worse off. If HKK were to lock in a forward rate now, it would automatically set the company up for losses. The rates in the forward market are significantly lower than the current exchange rate. The reason for that is, that the interest rates in the US are higher than in Austria. Consequently the US Dollar has to depreciate in the forward market to meet the no-arbitrage condition.

Unless this manufacturing company estimates the dollar to drop significantly in the future, hedging in this instance is going to make HKK even worse off. And if the Dollar appreciates, we cannot take advantage of that, since we have already looked in the forward exchange rate.

If we assume no OKB financing we are using the risk free rate of 13.75%. This consists of the Austrian schilling borrowing costs of 12.75% plus the 1% spread.

In this instance with no exchange rate risk, we get a Net Present Value (NPV) of -23.26. The discounted cash flows decrease every year, once we take into consideration after tax cash flows and the WACC. We calculated this WACC to be 14.75%.

The total amount to be received by HKK in the Costa Rica contract is As300 million, with the first year having an initial down payment equating to 10% of total revenue. This figure was As30 million. The next 5 years saw equal cash flows of As54 Million.

IF HKK were to pursue the OKB financing option, the terms are stated that OKB limit the amount they lend to any one exporter of 20% of annual exports.

HKK’s sales were expected to decline to As2.5 billion for 1981. We discovered however, that this equates to As500 million (.20 x As2.5 Billion), which is greater than the cost of As200 million anyway. This certainly makes the contract all the more attractive.

The risk free rate with OKB financing is also lower at 8.75%. This obviously changes our WACC as well, reducing it to 13.75% based on our calculations. Even though with OKB financing we experience a negative NPV, it is higher that in the assumption where we have no OKB financing.

The currency exposure does probably not need to be covered, mainly based on the fact that the US currency is appreciating. Despite predictions that the dollar will decline, this will take some time.

The dollar will only decline after extended periods of declining interest rates, which can often take a number of years. Interest rates usually deviate in small increments and thus to fall by 3-4 percentage

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