1. What is the currency risk exposure facing Merton? What dimension is more relevant in the case of Merton: transaction exposure, translation exposure, or economic exposure?
Merton Electronics is a company in the United States that imports from both Japanese and Taiwanese suppliers, to then be distributed nationally. Both suppliers invoice in their local currencies (Japanese Yen and Taiwanese Dollars, respectively). The mechanics of payments are as follows: Merton places an order, and the Asian supplier ships within 60 days. Payments are done 30 days from the end of the delivery month, but the spot price on the last day of the month in which the order is placed is used for the invoice.
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However, in the absence of historical data on futures prices, it is difficult for us to perform this calculation.
Therefore we would suggest that in this case Merton should look at hedging all their positions in Yen, 100%. They could hedge the positions by purchasing Yen futures at the time when they make the orders for the month and know their future need for Yen.
The 90 day payment window means that they would have a 90 day hedging and protection against unexpected currency fluctuations. In the case when future contracts expire out of sync of the invoicing cycles, Merton could invest the Yen purchased in a deposit account until the payment date. This means they would not be exposed to further $/Yen fluctuations at this time.
To take the assessment one step further they could look at calculating a limit on losses from currency fluctuations and then only hedge a percentage of their position to match the maximum losses to their limit. This would be done in the case that their main aim is to avoid bankruptcy and they are aware of the loss limits.
4. How would you hedge it?
We calculate explicitly the payoff of each of the following asset classes: futures; forward; money market; options, exotics. As indicated in the case, we consider the example of a 300 million Yen exposure arising from the goods that were ordered in January 1998 and are due for payment in April of the same year. The January 22 market rates will be used for the calculations.
* Forward. A possibility for Merton is to purchase a 90-day Forward Yen. As of January 22, the price is $0.7968 per ¥100. This eliminates entirely the risk that the Yen appreciates but would also eliminate any upside in case of a US dollar appreciation. With this hedge, Merton would have to pay $2,390,400.
* Futures. Merton could also purchase standardized futures. As of January 22 the March Yen futures is $0.7928. However notice that the payment is not due until April so there is a 1-month gap.
* It is impossible to know the 30-day Euroyen interest rate that will be available in March. However, we could assume that as an approximation Merton would require ¥299,906,279 in March and invest for 30 days at a rate of 0.375% per annum (or 0.03125% for 30 days).
* To this effect, Merton would enter a Futures contract worth $2,377,657. Notice this option does not fully eliminate risk.
* Money market. Another possibility is for Merton to borrow US dollars on January 22, change them at spot prices for Yen, invest these Yen for 90 days in a money market account, after which the payment to suppliers in Japan and interests in the US are settled.