When in Doubt, Hedge! It was a hot, humid afternoon in April. Kirk could feel th
ID: 2784655 • Letter: W
Question
When in Doubt, Hedge!
It was a hot, humid afternoon in April. Kirk could feel the pressure mounting. The memo on his desk read, “Please see me immediately!” Kirk knew that, sooner or later, his boss, Brian Daltrey, was going to ask him to implement some quick remedies to improve the profit situation. The quarterly financial statements had just been published and for the fourth quarter in a row, The Pre-Fab Pipe Corporation had reported a sharp drop in earnings per share despite a consistent increase in revenues. Needless to say, the shareholders were irate and the public relations department had been inundated with calls from concerned shareholders wondering what was going on. In fact, at the annual meeting held last quarter, the firm’s shrinking profits were the main topic of discussion. It led to the early retirement of the Chief Financial Officer, Mitch Graves.
The Pre-Fab Pipe Corporation, headquartered in Delaware, had established manufacturing facilities in Illinois, California, Ohio, and Pennsylvania. It specialized in the manufacture of high-grade copper piping of various thicknesses and circular dimensions. The pipes were used primarily in commercial and residential applications. 70% of its sales were accounted for by exports to the United Kingdom while the rest came from sales to wholesalers in the United States.
Over the past year, copper prices had fluctuated significantly (Table 1). The firm had been unable to purchase high-grade copper at stable prices, leading to a significant erosion of corporate profits despite surging sales.
The orders had been booked at a time when the price of copper was at its lowest level in twelve months ($2.62/lb.). That was the price that had been figured into the cost structure. Unfortunately, due to the stiff competition that characterized the piping industry, Pre-Fab was unable to shift the price increases on to the wholesalers. To make matters worse, the U.S. dollar had strengthened significantly over the prior 12 months resulting in further loss of profits upon conversion of British pounds into dollars. The dollar had gone from $1.55 per British pound, 12 months ago, to its current level of $1.42 per British pound. Due to the fierce competition in the overseas market, British wholesalers were able to negotiate very favorable terms including 90 days credit and payment in British pounds.
Part of the problem at Pre-Fab was that the previous CFO, Mitch Graves, had not been very familiar with the mechanics of the derivatives market. He had, therefore, not hedged the company’s commodity and exchange rate exposures at all. Upon Mitch’s retirement, Brian Daltrey, was appointed as the CFO. Brian’s first move was to recruit Kirk Sheehan, a derivatives expert. Kirk had earned an MBA in Finance at a major mid-western university and had worked for five years at the Chicago Mercantile Exchange, prior to joining Pre-Fab. The company had made him an offer that was too good to resist and Kirk knew that sooner or later the pressure would be on to prove his worth.
In preparation for the meeting with Brian, Kirk gathered information from the purchasing, sales, payables, and receivables departments. The sales department had booked orders for $130 million worth of pipes, 70% of which was from British clients. Kirk estimated that the company would need about 40 million pounds’ worth of high-grade copper by the end of three months to manufacture the pipes. Copper was being quoted at $2.72 per pound in the spot market and the British pound was quoted at $1.42 per pound. There was a likelihood that copper prices could go down and the dollar could weaken against the British pound, but the reverse could also happen. Kirk knew all too well that the market could go either way and remembered vividly what his prior boss used to often say, “When in doubt, hedge!” He feared that if copper prices were to appreciate along with the dollar, corporate profits would be significantly affected and he would be out looking for a job. He liked this company a lot and the lavish compensation package he had been offered was definitely worth keeping. “I had better come up with some effective hedging combinations,” thought Kirk. “This is no time to take a wait and see approach.”
Kirk tapped on his laptop and checked the Internet for the latest quotes on futures contracts trading on the British pound and on high-grade copper (see Tables 2–5). After jotting down some numbers and making some quick calculations, Kirk picked up the phone. “Brian,” he said with a smile on his face, “About that meeting you wanted to have with me…Can we meet right away?”
Table 1
Historical Spot Prices of High-Grade Copper
Month End
Price (cents/lb.)
May
2014
262.00
June
2014
264.75
July
2014
266.25
August
2014
265.70
September
2014
267.30
October
2014
264.45
November
2014
261.80
December
2014
270.40
January
2015
271.50
February
2015
273.35
March
2015
274.50
April
2015
272.00
Table 2
British Pound Futures – Contract Specifications
Trading Unit:
62500 British pounds
Price Quotation:
U. S.$ per pound
Trading Symbol:
BP
Initial Margin:
$1080 per contract
Maintenance Margin:
$800 per contract
Table 3
British Pound Futures Settlement Prices as of April 2015
Daily
EST
Prior Day
Open
Mth/Strike
Open
High
Low
Last
Sett
Chge
Vol.
Sett
Vol.
Int.
JUN15
1.4324
1.4332
1.4296
1.4312
1.4314
20
1792
1.4334
7901
35237
SEP15
1.4230
1.4256
1.4228
1.4250
1.4234
20
1
1.4254
31
880
TOTAL
1793
7932
36117
Table 4
Copper Futures – Contract Specifications
Trading Unit:
25000 lbs.
Price Quotation:
cents per lb. For example, 273.80 cents per lb.
Trading Symbol:
HG
Initial Margin:
$1350 per contract
Maintenance Margin:
$1000 per contract
Table 5
Copper Futures Settlement Prices as of April 2015
Contract
Expiration Date
Today’s Settle
Previous Settle
Volume
Daily High
Daily Low
HG 04 15
4/26/2015
271.5
272.1
64
271.6
270.2
HG 05 15
5/29/2015
271.7
272.3
7,039
272.4
271.2
HG 06 15
6/26/2015
272.05
272.65
58
272.15
271.95
HG 07 15
7/29/2015
272.4
270
1,942
273
271.9
HG08 15
8/28/2015
272.7
273.3
10
273.1
272.5
HG 09 15
9/26/2015
272.95
273.5
125
273.45
272.75
HG 10 15
10/29/2015
273.2
273.7
3
273.25
273.25
HG 11 15
11/25/2015
273.45
273.95
2
0
0
HG 12 15
12/27/2015
273.7
274.2
234
274.25
273.3
PLEASE ANSWER ALL OF THE FOLLOWING QUESTION
1)Brian questions Kirk, “What about forward contracts? Why not use forward contracts instead?” How should Kirk respond?
2) During their meeting, Brian told Kirk that the firm had been forced to use floating-rate loans for expansion due to their low credit rating. Although long-term rates were higher, the firm would have preferred to match the maturity of the debt with the duration of their financing need. Besides, short-term rates had been rising and were expected to continue going up due to rising inflation. The firm currently had borrowed $2 million at a floating rate of prime plus 1% (currently 6.5%). Longer-term, fixed rate debt was available at 9% per year. Brian had heard about interest rate swaps and asked Kirk to explain to him how Pre-Fab could use a swap to minimize their interest rate risk. How should Kirk respond?
3) Besides an interest rate swap, what strategies could Kirk recommend to Brian to help minimize the company’s exposure to interest rate risk?
Month End
Price (cents/lb.)
May
2014
262.00
June
2014
264.75
July
2014
266.25
August
2014
265.70
September
2014
267.30
October
2014
264.45
November
2014
261.80
December
2014
270.40
January
2015
271.50
February
2015
273.35
March
2015
274.50
April
2015
272.00
Explanation / Answer
1) Pre-Fab Pipe Corporation has hedging requirements against commodity price fluctuation risk and exchange rate risk. Future contract are better in this case as compared to forward contracts as the company has very standard and predictable requirements in terms of copper (commodity) order quantity and converion of fixed amount of foreign currency. In such standardized circumstances forwards are ill-suited as these derivatives are mostly customized for specific requirements and are usually created in small numbers. Hence, these will not be suitable for standard and large hedging requirements. Additionally, future contracts on account of possessing margin requirements and regulatory guarantee are default risk free which forwards are not. Futures because of being exchange traded are also more liquid and can be easily squared off before maturity in case requirement for their usage does not arise. Being exchange traded also ensures that futures contract prices stay within a specific band and do not undergo abrupt fluctuations.
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