Derivative Investment!

Currency Risk Exposure

DERIVATIVE INVESTMENT

CASE STUDY ANALYSIS On "Case 31: Merton Electronics Corporation"

Instructor

Sir Akbar Khan Group Members

Syed Aamir Abbas Asif Riaz Faisal Ayub BBA-VIII (ABC)

-1-


Table of Contents 2..................... ............................................ .............................................. .............................................. ............................................ .......................... ..... Introduction 4...................... ............................................. .............................................. .............................................. .......................................... ................... SWOT Analysis 4..................... ............................................ .............................................. .............................................. ................................................ ......................... Strengths: 5.............................................................................................................. Weaknesses: 7..................... ............................................ .............................................. .............................................. .......................................... ................... Opportunities: 8...................... ............................................. .............................................. .............................................. ................................................... ............................ Threats: 9...................... ............................................. .............................................. .............................................. ...................................................... ............................... Findings 11................................................................................. Company's Transaction Analysis 16.................... ........................................... .............................................. .............................................. ........................................... .................... Implementation 16.................................... Foreign Currency Risk: Minimizing Transaction Exposure 16................................................................................. The Foreign Exchange Market 17.................................. Non-Hedging Techniques to Minimize Transactions Exposure 17............................................................. Reducing Short-Term Foreign Currency Risk 17.................................................................................................... Forward Contracts 18.................... ........................................... .............................................. .............................................. .................................... ............. Futures Contracts 18....................... .............................................. .............................................. ............................... ........ Hedges Using the Money Market 18..................................................................................................................... Options 19.......................................................................................................... Cross Hedging 19......................................................... Mitigating Long-Term Currency Risk Exposure 19................................................................................................. Back-to-Back Loans 19................................................................................. Currency Swaps/Credit Swaps 20........................................................................................................ Recommendations 22....................... .............................................. .............................................. .............................................. ............................................... ........................ Conclusion 23.................... ........................................... .............................................. .............................................. ............................................ ........................... ...... References

Introduction We have study the whole case which is "Merton Electronics Corporation", then by using secondary resources on internet like by studying articles, journals, related web pages, research papers, term papers and different case study write-ups, then we have explore more information on this whole case, then we have discuss

-2-


main problems and issues of the companies with each other deeply and then finally we are able to write the case study analysis with collective effort.

Patricia Merton had been working in the company for two years when her father, Thomas Merton, died in the spring of 1991. As the only family member with experience in the company. Together with her mother, she controlled 65 percent of the share capital of the firm. The remaining shares were held by her father's brother and sister, their families, and a few long-service employees. Patricia Merton was dissatisfied with her company's result over the past year. Since it s founding in 1950 by Thomas Merton, Merton Electronics had been a distribution for GEC (General Electronic Company), a large manufacturer of electrical and electronics products for consumer and institutional markets. Over the years, in addition to the GEC products, the company had added no competing lines of electrical appliances, records, compact discs, and cassettes.

In 1980s it began to broaden its product lines by importing Japanese consumer electronics. Four years later, it entered into an exclusive import agreement with the Goldstone Corporation of Taiwan, a major producer and dealers throughout a broad geographical area.

By the beginning of the 1990s, the company had entered into the personal computer (PC) market, distributing both hardware and software products. It became the national distributor for Fuji Electronics, a major Japanese manufactured of PCs and related products in September 1993. This market had proven to be fast growing, accounting for more the half of total sales, although only about a third of profits, in 1997; this part of the business was becoming more and more competitive, as price cutting had become rampant from mail order and computer discount houses.

The company is facing heavy competition with slowing sales and increasingly smaller margins. One of the major issues facing the firm is the risk associated with the import of the foreign goods from Japan. In February 1996, Merton Electronics was reviewing its currency risk position. Its principal foreign suppliers were Japanese and fluctuations of the dollar/yen exchange rate during the past 23 years seemed to have had a serious impact on costs and earnings.

There are so many issues facing exporters, importers and others active in international trade. One of the things that continued to disturb her was the

-3-


volatility of yen and Taiwanese dollar. Due to the international nature of Merton Electronics' Business these problems occur and create serious impact on costs and revenue. Actually company was facing very high degree of currency risk. Currency risk is simply the degree to which the business is affected both positively and negatively by changes in exchange rates. It can refer to potential losses in investments, business transactions, and operating expenses due to fluctuations in exchange rates.

In this case, Merton is suffering from currency risk on payable accounts used to finance imports from Japanese suppliers. The exchange rate has been moving against Merton opening themselves up to a loss of over $900,000 in payments to the Japanese suppliers. Currency risk exposure can be further defined as translation exposure, transactional exposure, and operating exposure. This case also tells us to understanding foreign exchange, futures and options market information.

Finally, Merton Electronics is facing transaction exposure in regard to the payable to the Japanese firm for the goods that were ordered in January. Merton has different types of hedging from various options available to them and has to be careful in choosing the right type of hedging to maintain and resolve the currency risk exposure.

SWOT Analysis In Merton Electronics Corporation have so many strengths, weaknesses, opportunities and threats. We have to make SWOT analysis are as following:

Strengths:

-4-


Since its founding in



1950 by Thomas Merton, Merton Electronics had been a distribution for GEC (General Electronics Company), a large manufacturer of electrical and electronics products for consumer and institutional markets. In 1980s it began to



broaden its product line by importing Japanese consumer electronics. Four Years later, it



entered into an exclusive import agreement with the Goldstone Corporation of Taiwan, a major producer of television and other electronic equipment. 

By the beginning of

the 1990s, the company had entered into the Personal Computer (PC) market, distributing both hardware and software products. It became the



national distributor for Fuji Electronics, a major Japanese manufacturer of PCs and related product in September 1993. 

In 1997 sales had

risen by over 12 percent compared to the previous year, very close to budget. During the first



weeks of 1998, Merton had been taking advantage of the relative calm that usually marked that time of the year. The popularity of



the Fuji products, they had been able until 1995 to increase prices to partially offset their higher dollar costs. Since 1996, Merton



had systematically hedged each yen purchase order; purchases from Taiwanese suppliers were no hedged. 

Merton Electronic

Corporation has a strong historical background and now Patricia Merton a only experienced president working in this company.

Weaknesses: At the same time,



1997 earning fell by more than 40 %, reflecting increasingly difficult market conditions. Margins had been



flat or falling for the past three years, but 1997 was worst.

-5-




One of the things

that continued to disturb Patricia Merton was the volatility of the yen, and more recently, the Taiwanese dollar. 

Typical of Merton's

Japanese suppliers, Fuji Electronics had always insisted on invoicing in yen. Two years earlier,



toward the end of January 1996, concerned that the falling margins were at least partially due to the impact of a rising exchange rate. Patricia Merton's



General Manager Charles Brown did not prepare a detailed analysis of purchases before 1995; he estimated that "losses" were, if anything considerably larger. Merton was facing



significant currency risk. 

Merton Electronics

imported a higher portion of its product form Japan than some of its principal competitors, its profit margin were much more sensitive to the value of the yen. 

Somewhat

defensive he maintained that since neither he nor anyone else could have accurately predicted how the yen-dollar exchange rates would have moved during the past two years. When second time



Patricia Merton asked to her General Manager Brown to look at their experience over the past year, going back to January 1997. Although the yen



was still volatile, it had mainly weakened against the dollar during this period. By Hedging, the dollar cost of yen purchases had about $25.5 million during 1997. Besides going over



the hedging instruments, the banker raised a number of other issues for Merton consider. The company imported goods from its Japanese suppliers on a continuous basis throughout the year. Merton's banker



concluded by stressing that there was no "correct" hedging approach.

-6-


Opportunities: 

Operational

improvements had been maintained, keeping working capital and cash needs under control. Merton had secured



additional long-term financing and an increase in the company's credit line. Although continued



growth would require additional investment in new computer and office equipment and other fixed assets. 

By looking Merton

Electronics issues the banker advised them to hedge their yen purchases. 

If the purchases

had not been hedged, but the yen bought on the spot market when the invoices came due, the dollar cost would have been about $24.6 million- an almost $900,000 difference. 

By following Patricia

Merton's banker recommendation not to hedge the Taiwanese dollar purchase, the U.S dollar cost had been lower in 1997 by some $125,000. 

Banker admitted

that, with hindsight, not hedging would have been the best policy over the past one to two years. This meant that Merton would have bought the foreign currency on the spot market each time payments to the Asian Suppliers were made. 

Quickly checking

the numbers, he noted that if the ¥880 million worth of goods on order or already invoiced at the end of January were to be settled at current spot rate of ¥127, this would cost Merton about $6.93 million. Merton as a



president and major shareholder of the company thought to revive the alternative courses that the company might follow. 

Although the

company had been using forward contracts for some 18 months to hedge the yen purchase, Merton felt she needed to have her memory refreshed and asked the banker to outline once again how the different hedges worked.

-7-




According to the

banker, there were two basic choices when hedging. First one it could "Lock In" today an exchange rate that would be close to the current spot rate; the forward contracts they had been using provided this type of hedge. 

Second one they

could enter into an option contract that would set an upper bound on the cost of yen but allow them to take advantage of cheaper yen if that should happen by the time the invoices had to be paid. The option would



provide some of the advantages of not hedging and limit the disadvantagesbut at a cost. There were three



ways to lock in an exchange rate: a forward contract, a money market transaction, and a currency future contract. 

The currency option

contract was available from either banks or exchange. Bank or OTC (Over-



the-Counter) options can be tailored into meet the client's precise needs for maturity, amount or currency. Merton's banker



pointed out that besides dealing in "Plain Vanilla" (Standard) call and put options, he could also offer them Synthetic Exotic instruments. Synthetics were



combinations of calls, puts and sometimes forward contracts that were designed to meet particular risk/return objectives of a client. A so-called a cost option is one of the more widely used of these. 

Exotics were

options that had some particular feature that gave the buyer a lower premium at price of more risky payoff.

Threats: Merton expected

•

that continued growth would require investment in computer, office equipment and other fixed assets could be largely financed out of cash flow- if margins did not deteriorate further and working capital could be kept in line with sales.

-8-


Personal Computer

•

(PC) market had proven to be fast growing, accounting for more than half of total sales, although only about a third of profits, in 1997; this part of the business was becoming more and more competitive, as price cutting had become rampant from mail order and computer discount houses. At the beginning of

•

their agreement, Goldstone Corporation ha invoice in U.S. dollars but on the other hand Fuji Electronics had always insisted on invoicing in yen. As for purchases

•

from the Taiwanese suppliers, the banker told them the Taiwanese authorities managed their currency so that it stayed more or less fixed to the U.S. dollar, that even if it were to move it was likely to depreciate and for these reasons hedging would not be worthwhile. Merton's second

•

meeting with her banker and told him that since neither he nor anyone else could have accurately predicted how the yen-dollar exchange rate would moved during the past two years, because hedging the exposures was the most prudent policy for Merton. At that time

•

economic and political uncertainty in Japan and the rest of Asia. Merton asked to her

•

banker that what was the reasons that you had not encouraged them earlier to hedge the Taiwanese dollar payments, then the banker recalled his advice at the time was that it had been basically pegged to the U.S. dollar for several years and anyway was difficult to hedge satisfactorily because of exchange controls imposed by the Taiwan Authorities. Instead of

•

numerical calculation of $6.93 million, the company was already committed to pay $7.04 million since these purchases had been hedged when the goods were ordered. In other words, hedging appeared to have cost them some $110,000 at the present time.

Findings After SWOT analysis we have to reach on findings. We have observed different strengths, weaknesses, opportunities and threats. Now we have able to explain some findings in Merton Electronics Corporation case are as following:

-9-




Currency risk exposure is the dollar amount that is at risk if exchange

rates move in an unfavorable direction. 

A company has currency exposure when the currencies for its

expenditures and revenues are not the same. 

Future payments or distributions payable in foreign currency carry the risk

that the foreign currency will depreciate in value before the foreign currency payment is received and converted into US dollars. 

The company is facing heavy competition with slowing sales and

increasingly smaller margins. 

One of the major issues facing the firm is the risk associated with the

import of the foreign goods from Japan. 

There are so many issues facing exporters, importers and others active in

international trade. One of the things that continued to disturb her was the volatility of yen and Taiwanese dollar. 

Merton Electronics is facing transaction exposure in regard to the payable

to the Japanese firm for the goods that were ordered in January. 

The falling margins were at least partially due to the impact of a rising

exchange rate. Merton's banker



concluded by stressing that there was no "correct" hedging approach. 

Although the

company had been using forward contracts for some 18 months to hedge the yen purchase. There were two



basic choices when hedging. First one it could "Lock In" today an exchange rate that would be close to the current spot rate; the forward contracts they had been using provided this type of hedge. 

Second one they

could enter into an option contract that would set an upper bound on the cost of yen but allow them to take advantage of cheaper yen if that should happen by the time the invoices had to be paid. 

There were three

ways to lock in an exchange rate: a forward contract, a money market transaction, and a currency future contract. Synthetics were



combinations of calls, puts and sometimes forward contracts that were

-10-


designed to meet particular risk/return objectives of a client. A so-called a cost option is one of the more widely used of these. Exotics were



options that had some particular feature that gave the buyer a lower premium at price of more risky payoff. One such area of



particular risk is known as transaction risk and is associated with foreign exchange rates.

Company's Transaction Analysis A company has currency exposure when the currencies for its expenditures and revenues are not the same. Future payments or distributions payable in foreign currency carry the risk that the foreign currency will depreciate in value before the foreign currency payment is received and converted into US dollars. Although there is a chance for profit, most businesses and lenders give up that chance in order to eliminate the risk of currency exchange loss. It is measured as the amount in receivables or payables the company has committed to, for which the exchange rate has not been determined.

A currency is exposed to exchange rate fluctuations to the extent that it is used to conduct transactions with external markets. The greater the proportions of “inter-currency” exchange to total monetary transactions for a given market, the greater the exposure to changes in exchange rates. Businesses conducting international trade are exposed to exchange rate fluctuations in proportion to their total volume of transactions. As the magnitude of “inter-currency transactions” increases relative to aggregate transactions, a business unit realizes greater exposure to exchange rate fluctuations.

By defining currency exposure as the proportion of “inter-currency transactions” to total transactions, greater management attention can be aimed at operations with a high degree of exposed risk to exchange rate changes.

-11-


If Merton Electronics were to not hedge their currency risk exposure, the value of their payables will fluctuate with the value of the Yen. As can be seen in the graph below, if the Yen appreciates against the dollar, Merton will lose money due to their exposure. If the Yen depreciates, Merton will make a profit due to their exposure.

By entering into a forward contract hedge, Merton could lock in the exchange rate that they will pay in three months, now. This exchange rate would be $0.7952 per ¥100. Therefore, Merton could eliminate the risk of the Yen appreciating. However, if the Yen depreciated, Merton has forfeited these possible gains.

-12-


If Merton were to use the money market hedge, it would need ¥297,200,642.5 in order to have ¥300,000,000 in 90 days. This means that Merton will need to put $2,332,727.84 into a Yen money market account. The interest on this loan will be $51,591. By doing this, Merton can again eliminate the risk of the yen appreciating before payment is due but takes the risk that the yen will depreciate.

If Merton uses the yen futures hedge, it would need to purchase 24 contacts. If the Yen depreciates, Merton can wait until the futures mature and take the yen to pay suppliers. If the Yen appreciates, Merton will have to pay their suppliers more than three months earlier but the cost will be offset by the gain in Merton’s futures. Therefore, again Merton can eliminate the risk of the yen appreciating but runs the risk of the yen depreciating and not benefiting. If Merton purchases April options on the CME, it would incur a cost of $62,400. However, this is the most that Merton could lose. If the yen appreciates, Merton will exercise the call options and take delivery of the yen used to pay its suppliers. If the yen depreciates, Merton will let the options mature unexercised, and buy yen on the spot market. For this higher up front cost, Merton has eliminated most of its risk.

-13-


Merton could also purchase 90-day yen call options over the OTC market. These options would cost $74,700 and would work the same as the CME options. If the yen were to appreciate, Merton would exercise the options at an exchange rate of $0.7968 and take delivery of the yen to pay suppliers. If the yen depreciates, Merton would not exercise the options but buy the yen on the spot market in three months.

A company may find that they are uncomfortable with the risks associated with changing interest rates on their debt. This can come in the form of interest rates on the company’s debt and can be handled through the use of an interest rate swap.

-14-


As far as the hedging is concerned, Merton lost around $900,000 due to wrong hedging decisions. Instead of hedging Taiwanese dollars, they hedged Japanese yen, which devalued compared to U.S. dollars. Merton should have locked the Taiwanese dollar at a particular rate with the bank while they should have purchased the Japanese yen at the spot rate from the market. Since they are exposed to a 90-day currency risk, we believe they should hedge at the time when the order is placed. We are recommending this specifically taking in to consideration Merton’s current financial conditions. Looking at the Merton balance sheet (exhibit2), it is quite evident that the amount of Accounts payable ($ 3,670,000) in foreign currency is quite high. It means that if they don’t hedge their funds and buy the yen at the spot rates, then at that time there is a fair amount of uncertainty tied with it. In case the yen becomes stronger in comparison to dollars then they will have to pay a huge amount of money, which will further squeeze profit margins and they will be left with little funds. If they hedge their funds then they at know how much they have to pay. Even when we consider their assets and the cash that they have in their hands, it is not very large. This means that they often revert back to their short term financing to match their working capital with the accounts payable requirements. Instead of locking in the funds at the forward rates, they should go for the “yen future hedge” traded on the Chicago Mercantile Exchange (CME) or the Over the Counter (OTC). This will give them the flexibility to trade their instrument if yen is forecasted to appreciate in the near future.

-15-


Implementation Foreign Currency Risk: Minimizing Transaction Exposure For both in-house and retained international counsel, a thorough knowledge of international risk exposure techniques can serve as an effective way to supplement legal strategies for clients involved in international business transactions. While creative and thorough legal drafting can go a long way to reduce some international transactions risks, many business risks can be obviated in whole or in part by the financial markets. One such area of particular risk is known as transaction risk and is associated with foreign exchange rates.

The Foreign Exchange Market The foreign exchange market comprises the spot market and the forward or future market. The spot market is for foreign exchange delivered in two days or less. Transactions in the spot market quote rates of exchange prevalent at the time of the transactions. A bank will typically quote a bid and offer rate for the particular currency. The forward market is for foreign exchange to be delivered in three days or more. In quoting the forward rate of currency, a bank will use a rate at which it is willing to buy the currency (bid) and a rate at which it will sell a currency (offer) for delivery, typically one, two, three or six months after the transaction date.

-16-


Non-Hedging Techniques to Minimize Transactions Exposure Two obvious ways in which transactions exposure can be minimized, short of using the hedging techniques described below are: 1. Transferring exposure

2. Netting transaction exposure



The first of these is premised on transferring the transaction exposure to

another company.  A second way in which transaction risk can be minimized is by netting it

out. This is especially important for larger companies that do frequent and sizeable amounts of foreign currency transactions.

Reducing Short-Term Foreign Currency Risk For the company that wants to eliminate short-term transaction exposure (exposure of less than one year), a variety of hedging instruments are available at varying costs to the company.

Forward Contracts The most direct method of eliminating transaction exposure is to hedge the risk with a forward exchange contract. Forward rate contracts are often inaccessible for many small businesses. Banks often tend to quote unfavorable rates for smaller business because the bank bears the risk the company will not fulfill the forward rate contracts. Large spread in the forward rate quote suggests unfavorable offer terms. Banks will refuse to offer forward contracts at any rate to uncreditworthy companies. Companies those are not eligible for forward rate contracts have the option, however, of hedging transaction exposure with futures contracts.

-17-


Futures Contracts In principle, no differences exist between a futures market hedge and a forward market hedge. When the futures contract increases in value, the company loses that amount. When the futures contract decreases in value, it gains that amount.

Despite their advantages, futures contracts also contain some disadvantages. Because futures contract are

marked to market on

a daily basis, any losses must

be made up in cash on a daily basis, while the offsetting gain on the currency transaction will be deferred until the transaction actually occurs. This imbalance can result in a severe liquidity crisis for small companies and for individuals.

Another disadvantage of using futures contracts for hedging is that they trade only in standardized amounts and maturities. Companies may not have the choice of timing their receivables and payables to coincide with standardized futures contracts. Consequently, the hedges are not perfect.

Hedges Using the Money Market A company has the alternative of using a money market hedge if forward market hedges are not available or too expensive, and where a futures market hedge carries too much risk of insolvency. A money market hedge—called that way because it necessitates borrowing or lending in the short-term money market— enables a company with a future receivable or a future payable to make the required exchange of currencies at the current spot rate. In this case, even if forward and futures contracts are available, a money market hedge may be the least costly hedging alternative.

Options Currency options give one party the right, but not the obligation, to buy or sell a specific amount of currency at a specified exchange rate on or before an agreedupon date. If the exchange rate moves in favor of the option holder, the option can be exercised and the holder is protected from loss. On the other hand, if the rate moves against the holders, it can let the option expire, but profit, by selling the foreign currency in the spot market. Consequently, options are best characterized with potential for gain and no downside risk. Hedging in the options market enables businesses and individuals to reduce loses caused by unfavorable exchange rate changes, while preserving gains from favorable exchange rate changes. However, this flexibility has a cost.

-18-


Cross Hedging Thus far, a market for forward rates, futures contracts, credit or options in the foreign currency being hedged has been presumed to exist. But this may not be true in all cases, especially for small developing countries. In such cases, cross hedging may be the only hedging alternative available.

Cross hedging is a form of a hedge developed in a currency whose value is highly correlated with the value of the currency in which the receivable or payable is denominated. In some cases, it is relatively easy to find highly correlated currencies, because many smaller countries try to peg the exchange rate between their currency and some major currency such as the dollar, the franc or euro. However, these currencies may not be perfectly correlated because efforts to peg values frequently fail .

Mitigating Long-Term Currency Risk Exposure Theoretically, the same hedging instruments discussed above to alleviate shortterm currency risk can be used to hedge long-term transaction exposure. However, at present, there is a limited market for currency futures options with maturities greater than one year.

Back-to-Back Loans Multinational corporations can often reduce their respective long-term currency risk exposure by arranging parallel or back-to-back loans. Under this arrangement, the companies are entering into a purely bilateral arrangement outside the scope of the foreign exchange markets. Neither company is affected by exchange rate fluctuations. Nevertheless, both companies remain exposed to default risk because the obligation of one company is not avoided by the failure of the other company to repay its loan.

Currency Swaps/Credit Swaps Swaps are like packages of forward contracts. Currency swaps can be used to avoid the credit risk associated with a parallel loan. In broad terms, a currency swap is an agreement by two companies to exchange specified amounts of currency now and to reverse the exchange at some point in the future. The lack of credit risk arises from the nature of a currency swap. Default on a currency swap means that the currencies are not exchanged in the future, while default on

-19-


a parallel loan means that the loan is not repaid. Unlike a parallel loan, default on a currency swap entails no loss of investment or earnings. The only risk in a currency swap is that the companies must exchange the foreign currency in the foreign exchange market at the new exchange rate.

Recommendations We as a team recommend that Merton should do their budgeting once a month if possible or at least as frequently as possible. This is very important as they buy most of their goods from Asia and they have to make all their payments in foreign currency. Since the currency market is highly volatile, they will have to keep track of the past trends in Japanese yen and the Taiwanese dollar. If they fail to do this they will fall into a big trap as they have already had huge losses in the present situation. It is important to mention here that the losses they have made of $900,000 dollars exactly match their pre-tax profits (exhibit 2). If they can come up with right kind of mix of hedging and buying the currency at the spot rates, Merton can double their profits and they will not have to worry about the future competition in the market.

On the question of whether they should go for a full hedging strategy or just hedge part of the total foreign currency payments greatly depends on the company’s objective. If the risk in the near future is very high and the political situation in a particular country, (e.g. Japan) is not stable then they should certainly hedge the yen as it is a safe bet rather then to expose themselves to the uncertain risk of having a significant loss. Review of the currency market is of supreme importance as it changes with even a single piece of information. Chances are there that a nonfinancial company with limited competence in this area will loose often rather than make profits. So Merton will have to be careful in choosing the right type of hedging from the various options available to them.

Speculation regarding derivatives is usually risky. However, companies with a comparative advantage can make profits speculating because they have an edge over the other market participants. This edge may come in the form of expert traders, superior models, or some other advantage. Therefore, nonfinancial companies should not try to speculate in order to make money from currency or interest rate movements. They do not have the needed advantage to make money or a proper understanding of the risks involved. Speculating in derivatives

-20-


is also probably beyond the acceptable risk of the company’s owners. If they were interested in trading derivatives, they could do so themselves or invest in an investment bank that speculates on currency or interest rate movements.

A nonfinancial company may want to try to speculate in order to profit from movements in commodity prices. If the company produces, distributes, or deals with the commodity in another way, it may have knowledge of the commodity that will give it an edge and enable it to make profits from commodity derivatives. However, the company should be aware of the risks involved with speculating. For example, many energy producers and distributors recently became involved with trading energy and energy derivatives. Many of these companies have had trouble measuring the risks involved with speculating.

-21-


Conclusion The risk of currency exposure can be mitigated or even eliminated in its entirety by the techniques and instruments described in this article. How much currency risk exposure remains depends on the instrument selected. Many instruments do not hedge transaction exposure perfectly, but are more accessible to the individual and small to medium size companies. Instruments used to more completely hedge currency exposure, such as put and call options, may contain sizeable transaction costs.

In final words, a company should not speculate about movements in currencies, interest rates, or commodities unless it has a comparative advantage over the other market participants and fully understand the risks. This is difficult for nonfinancial companies because financial companies have many resources such as skilled traders and sophisticated models that give them the edge.

-22-


References 1.http://www.ecch.com/casesearch/product_details.cfm?id=8581 2.http://students.clarku.edu/~adowns/portfolio/Financial %20Modelig/Derivatives-Merton%20Electronics.pdf

3.http://knowledge.insead.edu/abstract.cfm?ct=4422 4.http://termpaperaccess.com/doc_merton_electronics_ksrpk.html 5.http://papers.ssrn.com/sol3/papers.cfm?abstract_id=128112 6.http://www.oppapers.com/essays/Merton/190705 7.Remmers , Lee Lee, Merton Electronics (1996). Available at SSRN: http://ssrn.com/abstract=128112

8.http://www.vsb.org/publications/valawyer/june_july01/kelley.pdf

-23-


-24-

Derivative Investment!

Recommend Documents