Baldwin Wallace University

International Transaction Analysis and Risk Evaluation

Carolina Ribeiro Vogt

Filipe Gonçalves Lemos

Rafael Rezende

BUS 444 – International Finance Management

Dr. Christian Nsiah

April 30, 2014

 

Table of Contents

Introduction ................................................................................................................................ 3

The Company ............................................................................................................................. 3

The Country ................................................................................................................................ 5

The Transaction .......................................................................................................................... 5

Risks of transaction ................................................................................................................ 6

Hedging the Transaction ............................................................................................................ 7

Unhedged ................................................................................................................................ 7

A) 30% of the contract’s value ...................................................................................... 7

B) 10% in stocks ........................................................................................................... 8

Forward Contracts .................................................................................................................. 9

A) 30% of the contract’s value ...................................................................................... 9

B) 10% in stocks ......................................................................................................... 10

Future contracts .................................................................................................................... 10

Money Market hedge ............................................................................................................ 11

Options .................................................................................................................................. 12

A) 30% of the contract’s value ....................................................................................... 12

B) 10% in stocks ............................................................................................................. 14

Swaps .................................................................................................................................... 18

Conclusion ................................................................................................................................ 18

Table 1 .................................................................................................................................. 20

Table 2 .................................................................................................................................. 21

Works Cited .............................................................................................................................. 23

3    

Introduction

As the world become more and more globalized, companies located in different parts

of the globe need to extend their production and sales to other countries to gain advantages

against their competitors, such as economies of scale, economies of scope, or even product

diversification.

This need of doing business with other countries created a necessity to manage

different types of currency. However, as companies start to do international business, they

become exposed to different risks like political risks, foreign exchange risks, economical

risks, or transaction costs.

This paper has the objective to demonstrate an international transaction between two

different currencies: Real (the Brazilian currency) and the Pound (the British currency). The

paper is divided in 4 parts. The first part describes about a company WiFindme, a company

that sells a type of software that enable stores to communicate with their clients, that is doing

international business with BR Malls, the largest integrated shopping mall company in Brazil.

The second part describes about Brazil and the risks that investors can suffer by doing

business with companies located in Brazil, like political, economic, and social problems. The

third part presents the transaction between the two companies above and explains the possible

risks of this type of transaction, like changes in the exchange rate or interest rates. As

international transactions involve foreign currency exposure, the last part of this paper will

present different possibilities of hedging against the transaction costs, and the best choice for

this type of transaction.

The Company

Based in London, WiFindme got famous thanks to its groundbreaking technology to

enhance costumers experience when they shop. WiFindme’s technology can enable stores to

4    

communicate with their primary costumers when they are close to the store, or point of

interest.

Thanks to Wi-Fi routers spread around towns, commercial areas and shopping malls as

soon as the costumers enter the radius of the Wi-Fi signal he or she gets an alert on their

phone saying all the stores of their interest and all the best deals around them. The success of

this product is based on the great software sold to the stores. With the software the store can

control what kind of message the costumers will get, who is getting the deals, they can even

create virtual deals only using WiFindme software. But imagine your phone buzzing every

single time when you go downtown, to deal with this concern WiFindme create an app that

the client had full control on what he or she is getting on their phone. They can decide what

kind of stores can reach them and what time; this creates a file of their habits of shopping, the

biggest asset of WiFindme.

Knowing what your costumer’s preferences are creates the great differentials between

WiFindme and its competitors. It encourages the company to develop new tools to help stores

to communicate with their costumers more efficiently. WiFindme has been expanding since

2013. WiFindme management is thrilled to get in one of the biggest markets in the world,

such as Brazil, thanks to huge shopping malls culture allied with a growing population and the

increasing number of smartphones sold in Brazil. This is the perfect combination to sell the

WiFindme Store Management Software to shopping malls.

WiFindme just signed a contract with the biggest Mall Manager in Brazil, BRMalls.

They alone manage 49 malls totaling 8985 stores. The best thing of the deal with BRMalls is

that the mall administration has the top-down power to make all the stores in that shopping to

make use of WiFindme software. This fact makes this contract extremely attractive to

WiFindme. It is extremely interesting for BRMalls as well, they are interested to boost their

average spend ticket per shopping and this software can help them do that.

5    

The Country

As the world’s fifth largest economy, a large domestic market, and a stable social and

political background, Brazil also plays a leading role in Latin American economy and politics.

However, it’s important to analyze some specific economic indicators before making some

business in Brazil.

The Brazilian inflation registered 6.31% in 2013 and the interest rate of 11%. Also, the

Brazilian Central Bank (BACEN) uses monetary policies to control and safeguard the stability

of the national currency’s buying power and the solvency and efficiency of the financial

system. For example, if the inflation is too high, BACEN would raise the interest rate, which

would make the population retain their money into the banks instead of buying goods and

putting more money into the economy.

Another risk involved in doing business with Brazil is how the government can use

exchange rate policies to influence the appreciation or depreciation of real against the dollar.

For example, if the dollar appreciated against the real, the BACEN would buy dollars and

inject it in the economy and rise the interest rate to attract foreign investments as well trying

to drop the exchange rate between the two currencies.

The Transaction

Consider that BR Malls Company is buying 8985 software’s license from WiFindMe

Company. Each license costs R$ 4,999.00, and each store has to pay a monthly fee to keep the

service working. This fee costs R$ 599.00 per month. The total transaction will be R$

109,500,195.00, equivalent of $ $49,374,231.21 or £29,525,632.58, using the spot of

R$2.21776/$ and £0.59799/$. Thus, the spot cross-exchange rate is £0.26964/R$. The

forward exchange rate was calculated using the forward June quotation for Dollar/Real and

Dollar/Pound, because the July’s quotation wasn’t available for Dollar/Pound. The

Dollar/Real forward exchange rate is $0.4416/R$ and the Dollar/Pound forward exchange rate

is $1.6815/£. Thus, the cross exchange rate between Pound/Real is £0.2626/R$.

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The payment will be separated in three parts:

• BRMalls will pay 60% of the contract’s value on the day the contract was signed. This

payment will have the value of R$ R$ 65,700,117.00, equivalent to £17,715,379.55.

• BR Malls will pay 30% of the contract’s value 3 months from the date the contract

was signed. This payment will have the value of R$ 32,850,058.50. As the forward

rate is expected to be £0.2626/R$, the amount in pounds would be £8,626,425.36

• BR Malls will pay 10% of the contract’s value in stocks traded in the Brazilian stock

market – BM&FBovespa, equivalent to 586,504 stocks at the closing price of April

16th R$18.67. This amount is R$ 10,950,029.68 or £ 2,952,556.00, changing at the

spot rate.

Risks of transaction

One of the risks that WiFindMe is liable to suffer is the possibility of the company to

not honor its obligation. On the other hand, BRMalls is a well-known Brazilian company, and

it has a healthy net debt per EBITDA ratio (3,36x), that means that the company can pay their

debts using the EBITDA in 3.36 years. That amount of debt is common among the companies

of the shopping mall sector. Thus, the risk of default is unlikely to happen.

Another risk that WiFindMe can suffer with this transaction is the fall of BRMalls’

stock value. However, according to BTG Pactual, a Brazilian investment bank, the prediction

of the stock price could be R$ 21.00 in a 12-month period, providing 12.48% upside,

considering the closing stock price of April 16th of R$18.67.

The possibility of real depreciating against the pound is another risk involved in this

transaction. If the real depreciate against the pound, the company WiFindMe would lose

money, because when it converts the Reais into Pounds, it will be more costly. As the

standard deviation of the change in the spot rate is 8.55%, there is a possibility of the

depreciation of Real against the pound.

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Hedging the Transaction

There are different types of hedging this transaction. As the first part of the payment

occurs on the day that the contract was signed, WiFindMe will change the amount of R$

65,700,117.00, equivalent to £17,715,379.55, using the spot exchange rate of £0.26964/R$.

The hedge becomes possible with the second and third part of the transaction.

In the second part of the transaction, BRMalls will pay 30% of the contract’s value 3

months from the date the contract was signed. This payment can be hedged in different ways

that will be described below under the letter A.

The third part of the transaction is 10% of the contract’s value in stocks of BRMalls.

As described above, there is a chance that the value of each stock increases in 12.48% a year

from the date of assignment, but there is also the possibility that the value remains the same or

decreases. It is also important to remember that the company WiFindMe is also exposed to the

variation of the currency exchange rate in each of the scenarios above. This hedge process

will be under the letter B.

Unhedged

Unhedged transactions are very risky. However, it’s the one that it can bring the

maximum return or the maximum loss. Unhedged transactions make the “investor”

completely exposed to any change or variation of prices and exchange rates. There are some

cases which an unhedged transaction is almost completely safe, such as, corporations that

detain monopoly power, because assuming that the company is the only one that makes the

good, it can impose to the customers to pay in the currency that is more favorable to the seller,

and currencies that have a standard deviation of the change in the spot rate close to zero.

A) 30% of the contract’s value

In this transaction, if the company decide to not hedge against the depreciation of the

Real, and assume all the risks of the fall of the cross exchange rate between Pound/Real, the

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company would receive less than what was agreed.

If the company sell R$ 32,850,058.50 (30% of the contract’s value) using the expected

forward cross exchange rate of £0.2626/R$, it would totalize an amount of £8,626,425.36.

However, the cross exchange rate has a standard deviation of 8.02%, which could lead the

cross exchange rate to £0.2912/R$ or £0.2481/R$. In these scenarios, the amount gain by the

WiFindMe Company would be £9,565,973.04 or £8,150,099.52. Thus, if the company don’t

hedge, there is a possibility of gaining £939,547.68 or losing £476,325.84.

B) 10% in stocks

WiFindMe Company has the option of remaining unhedged with this part of the payment.

However, the company would be exposed to the variation of the stock price and the exchange

rate. It is known that the BRMalls stocks performance follow the performance of the Ibovespa

index, and that the Ibovespa index has a positive relation with the real exchange rate. This

means that when the Real appreciates, the Ibovespa index shows a positive performance and

vice-versa.

The stock price can be affected by many different aspects besides the real exchange rate.

However, it is possible to predict a forward price using the standard deviation. The calculated

standard deviation for the stock is 14.55%. Using this data, it is possible to create three

different scenarios:

1) A year from now, WiFindMe will sell all the stocks by the lowest price calculated by the

standard deviation - R$ 15.95. The total amount gain would be R$9,354,738.80

(R$1,595,290.88 less than the original amount of the contract (586,504 stocks * 18.67 =

R$ 10,950,029.68)).

2) A year from now, the company will sell all the shares at the same price from the date of

the signature of the contract, R$ 18.67. This would give the exactly amount expected from

the beginning, R$ 10,950,029.68.

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3) A year from now, the stock price will reach the target price of R$ 21.00. If this case

happens, the company would win the equivalent amount of R$ 12,316,584.00. This would

give the company an extra R$ 1,366,554.32 if compared to the expected amount of R$

10,950,029.68.

Apart from the stock price, there is also the risk of the variation of the exchange rate. After

selling the stocks, the WiFindMe Company still needs to change the real to pound. Thus, if

the exchange rate turns out to be £0.2481/R$, the company would only gain £2,320,910.70

(case 1), if the exchange rate turns out to be £0.2626/R$, the company would gain

£2,727,652.39 (case 2), or if the exchange rate turns out to be £0.2912/R$, the company

would gain £3,055,744.49 (case 3).

Forward Contracts

One option that companies can hedge against their transaction exposure is using

forward contracts. According to Wong (2013), “the currency forward markets are not readily

available in many less-developed countries, and are just starting to develop in a rather slow

pace in many of the newly industrializing countries of Latin America and Asia Pacific”. This

case presents a transaction between one of the major currencies (the Pound) and one exotic

currency (the Real). Wong (2013) explains that international companies that are exposed to

exotic currencies should find cross hedging useful to manage their exchange rate risk

exposure through the use of forwards.

A) 30% of the contract’s value

To hedge using a forward contract, the WiFindMe Company would have to sign a

contract to sell Reais, three months from the date of the contract’s signature, at the forward

rate of £0.2626/R$, which will guaranty the amount of £8,626,425.36. Thus, the company

would sell its foreign currency receivable to eliminate its exchange risk exposure.

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If the Real depreciated against the pound and the company had not signed a forward

contract, WiFindMe could have lost £476,325.84 (£8,626,425.36 - £8,150,099.52). However,

if the real appreciated against the pound and the company signed the forward contract,

WiFindMe would no longer earn £9,565,973.04, but only £8,626,425.36, that is the company

would not receive £939,547.68 more.

B) 10% in stocks

Forward contracts are not the best approach to hedge against the payment in stock

options, because this part of the payment depends not only on the quotation of the exchange

rate, but also depends on the price of the stock. As Brazil’s economy is susceptible to changes

that affect the stock market, it would be risky to make a forward contract. Thus, the best

hedge approach for this payment is an American option, because WiFindMe Company can

exercise the option whenever is more favorable to it.

Future contracts

Future contracts are useful to hedge against transaction exposure. However, futures

contracts have standardized features, such as contract size and delivery date. It is important to

notice that the value of the transaction needs to be suitable to a future contract, otherwise

exact hedge would be extremely difficult. In relation to the delivery date, Grant (1982)

explains that “futures contract in the market index can be a perfect hedge only if the trader's

holding period corresponds to the delivery date of the futures contract”. One of the motives

that future contracts wouldn’t be useful as a way to hedge the transaction exposure is that the

contract was signed in April, and most of currency future contracts are trade in March, June,

September, and December, turning to be impossible to match the dates. Another fact is that

as the future is a traded contract, they usually don’t have exotic currencies, as the Real, to

trade.

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Money Market hedge

Money market is a hedging technique that, according to Eua and Resnick (2012), “the

firm may borrow (lend) in foreign currency to hedge its foreign currency receivables

(payables), thereby matching its assets and liabilities in the same currency”. The money

market hedge can be a good option to hedge against this transaction because, according to

Elvis Picardo (2014), “the money market hedge can be used effectively for currencies where

forward contracts are not readily available, such as exotic currencies or those that are not

widely traded”. Thus, to hedge using the money market strategy the company WiFindMe, that

has a receivable in Reais, may borrow in foreign currency (Reais) to match its asset with its

liability in the same currency.

The first step in this strategy is to find the amount of Real that the company should

borrow. For this step is important to remember the following data: i£=0.5% per year, iR$=11%

per year, the spot exchange rate is £0.26964/R$ and the forward exchange rate is £0.2626/R$.

The payment of 30% of the contract’s value will occur 3 months after the contract was

signed. Thus, it is important to change the interest rate for a trimestral rate instead of a year

rate.

i£ = ((1 + 0,005)^1/4 – 1) x 100 iR$ = ((1 + 0.11)^1/4 – 1) x 100 i£ = 0.1247% per quarter iR$ = 2.6433% per quarter

To hedge using the Money Market, the WiFindMe Company needs to borrow from the

Brazilian market the present value of R$ 32,004,094.28 (R$ 32,850,058.50 ÷ (1+0.026433))

to repay in 3 months, because with the interests the total amount will be the value of the

receivable. With this money, the company should buy Pounds using the spot rate of

£0.26964/R$, equivalent of £8,629,583.98. Then, WiFindMe should invest this amount in

U.K at the interest rate of 0.1247% during three months. In July, the company will collect its

receivable of R$32,850,058.50, and use it to pay the principle plus interests (R$

12  

32,004,094.28 x (1+0.026433)) in the same value. The company should also receive the

principle plus interests from the investment made in U.K, totalizing an amount of

£8,640,345.07 (£8,629,583.98 x (1+0.001247).

The final amount from the money market hedging is higher than the forward hedging

because of the unsustainable interest rate parity. Thus, it is better to hedge using the money

market strategy than the forward hedge, because the company WiFindMe will receive an extra

profit of £13,919.71 (£8,640,345.07 - £8,626,425.36).

Options

According to Eua and Resnick (2012), “an option is a contract giving the owner the

right, but not the obligation, to buy or sell a given quantity of an asset at a specified price at

same time in the future”. As the owner of the option does not need to exercise the option, the

option has a price, stipulated as the premium. There are two different kind of options, the

American and the European, and each option also can define if the currency will be bought or

sold. Eua and Resnick (2012) explain that an option to buy a certain asset is a call, and an

option to sell a certain asset is a put. The American option allows to exercise the contract at

any time during the contract. As it is possible to exercise the option whenever it is more

advantageous to the company, the premium is higher.

According to Ioannis Karatzas (1988) the European only allows the exercise at the

maturity of the contract, and for that the premium for the European option tends to be lower

than the premium for the American option.

A) 30% of the contract’s value

For this part of the transaction, the possible hedge would be using an European put

option, to sell Reais in three months forward. As there isn’t an available direct European

option between Pounds and Reais, it would be necessary to use an option based on the value

of the crude oil, because in developing countries, the exchange rate tends to follow the price

13  

of this commodity. For educational purposes, the hedge will be made using an European

contract between Pounds and Reais.

To hedge using this tool, the WiFindMe Company will need to sell the R$

32,850,058.50, at the exercise price of £0.2626/R$. This would be a European put option,

with a premium of £0.001928467 per Real sold. This premium was calculated based on the

Black-Scholes Model, a model to price options, by calculating the annualized volatility of the

changing exchange rate, between pounds and reais. Assuming that this volatility is σ =

8.02%, the exercise price of £0.2626/R$, the interest rate in UK of 0.5%, the interest rate in

Brazil of 11%, and t = 3 months (90 ÷ 365), it is possible to find that d1 and d2 are equal to:

d1= (ln(S/E) + (r£ – rR$ + (σ²/2)) x t) ÷ σ x t^(1/2) = 0.168479521

d2 = d1 – (σ x t^1/2) = 0.128654283

With d1 and d2 it is possible to find the premium for the european call and put for the option

being the call premium of 0.011796166 per pound, and the put premium of 0.001928467 per

pound.

)N()N( 210$ dEedeSc TrTr Ruk ×−×= −−

TrT

RedFdEp $)]N()N([ 12−−×−−×=

On the maturity of the contract, if in 3 months the pound appreciates against the Real,

the company should exercise the option, because it will sell Reais at a better exchange rate

(£0.2626/R$) than in the market (£0.2481/R$). However, if the pound depreciates against the

Real, the company should not exercise the contract, because it can sell the Reais at a better

exchange rate in the market. If this scenario happens, the company will only pay the premium

of £0.001928467 per each Real.

14  

Assuming that the exchange rate is £0.2481 (or R$4.03/£), the company would

exercise the contract selling R$ 32,850,058.50 at the exchange rate of £0.2626/R$ (R$3.81/£),

resulting in an amount of £8,626,425.36. On the other hand, if the exchange rate becomes

£0.2912 (R$3.43/£), WiFindMe Company should sell the R$ 32,850,058.50 at current spot,

instead of exercising the contract, resulting in an amount of £9,565,937.04, and it would pay

the premium of £63,350.25, totalizing the profit of £9,502,587.79.

B) 10% in stocks

To hedge against the transaction exposure for this part, WiFindMe Company needs to

evaluate the relationship between the stock prices and the exchange rate. For this, it is

important to notice that the BRMalls stock’s performance follows the Ibovespa Index

(Brazilian 50 most traded companies in the Brazilian stock market), and the Ibovespa Index is

positively related to the appreciation of Real against the dollar. Thus, it is possible to

conclude that there is a positive correlation between the appreciation of the stocks from

BRMalls stocks with the appreciation of Real.

15  

As WiFindMe Company does not have a stipulate date to sell the stocks, because the

company wants to maximize its profit, the company should hedge this transaction using an

American option, allowing the company to exercise the contract whenever the target price is

favorable.

To find out the correct value that the company should hedge against, it is important to

evaluate the extent to which the value of the firm asset would be affected by unanticipated

changes in exchange rates. Thus, the company can assume the following scenario:

SCENARIOS PROBABILITY P* S P (S x P*)

1 25% R$ 9,354,738.80 £0.2481/R$ £2,320,910.70

2 25% R$ 10,950,029.68 £0.2626/R$ £2,875,477.79

3 50% R$12,316,584.00 £0.2912/R$ £3,586,589.26.

The probabilities were predicted based on how the economy of Brazil will perform

and how it would affect the performance of BRMalls. Considering that Brazil is hosting main

international sports events, like the world cup and the Olympic Games, this would boost

Brazilian’s economy through tourism. It is also important to take into consideration that 2014

is an election year. Thus, the probability that the exchange rate and the stock value will raise

is 50%.

In the scenario 1, the considered stock price would be less than the value on April 16th

(R$18.67), using the standard deviation of 14.55% (R$15.95). The numbers of stocks

received as part of payment is 586,504. This would generate an amount of R$ 9,354,738.80.

The exchange rate would also be less than the forward rate of £0.2626/R$, by 8.02%

(£0.2481). Thus, the amount gained by WiFindMe Company after selling the stocks and

changing the Reais into Pounds would be £2,320,910.70.

16  

In the scenario 2, the considered stock price would remain the same as the value on

April 16th (R$18.67). The numbers of stocks received as part of payment is 586,504. This

would generate an amount of R$ 10,950,029.68. The exchange rate would also be the same

the forward rate of £0.2626/R$. Thus, the amount gained by WiFindMe Company after

selling the stocks and changing the Reais into Pounds would be £2,875,477.79.

In the scenario 3, the considered stock price would be higher than the value on April

16th (R$18.67), assuming the target price of R$ 21.00. The numbers of stocks received as part

of payment is 586,504. This would generate an amount of R$12,316,584.00. The exchange

rate would also be higher than the forward rate of £0.2626/R$, by 8.02% (£0.2912). Thus, the

amount gained by WiFindMe Company after selling the stocks and changing the Reais into

Pounds would be £3,586,589.26.

By looking to these different scenarios, the company would assume a risky position,

because it could gain £2,320,910.70 or £3,586,589.26. To minimize this range, the company

should hedge against the economic exposure by finding the Beta, through the variation of the

exchange rate and the covariance between the pound value of the assets and the exchange

rate, as shown below:

Exchange rate Mean: (0.2481+0.2626+0.2912) ÷ 3 = £0.2673/R$

VAR(s) = [(0.25(0.2481-0.2673)²) + (0.25(0.2626-0.2673)²) + (0.50(0.2912-0.2673)²)

VAR(s) = 0.000383288

Mean of the asset’s pound price: (£2,320,910.70 + £2,875,477.79 + £3,586,589.26) ÷ 3 =

£2,927,659.25

COV (P,S) = ((0.25) x (2,320,910.70 – 2,927,659.25) x (0.2481-0.2673)) + ((0.25) x

(2,875,477.79 - 2,927,659.25) x (0.2626-0.2673)) + ((0.50) x (3,586,589.25 - 2,927,659.25) x

(0.2912-0.2673)) = 10,847.9199

β = COV (P,S) ÷ VAR(s) = 10,847.9199 ÷ 0. 000383288 = R$28,302,268.53

17  

WiFindMe Company should sign an American put option contract to sell R$

28,302,268.53 at the forward rate of £0.2626 to hedge against the fluctuation of the stock

price and the exchange rate. By doing this, the company would narrow its profit range,

minimizing the risk of losing money. The premium for this option will be £0.00704 per pound

(difference between the strike prince of £0.2626 and the spot price of £0.26964). Thus, the

total premium would be £199,247.97, and the total amount at the end of this part of the

transaction would be £7,232,927.74. However, the company should take into consideration

the variation in the exchange rate, as described below:

P* S P (SxP*)

R$ 9,354,738.80 £0.2481/R$ £2,320,910.70

R$ 10,950,029.68 £0.2626/R$ £2,875,477.79

R$12,316,584.00 £0.2912/R$ £3,586,589.26

If the scenario 1 occurs, the forward exchange rate would be £0.2481/R$. Thus, the

WiFindMe Company should exercise the option contract and sell R$28,302,268.53 at the

forward exchange rate of £0.2626/R$, and pay the premium, totalizing an amount of

£7,232,927.74. Then, the company would have to buy the difference in Reais between the

Beta and the P* (R$28,302,268.53 - R$ 9,354,738.80) = R$ 18,947,529.73 at the spot of

£0.2481/R$, costing £4,700,882.13, to pay the rest of the option contract. Thus, the net flow

would be £7,232,927.74. - £4,700,882.13 = £2,532,045.61.

If the scenario 2 occurs, the forward exchange rate will be the same as the strike price

of the contract. Thus, the WiFindMe Company should sell R$28,302,268.53 at the forward

exchange rate of £0.2626/R$, and pay the premium of £199,247.97, totalizing an amount of

SCENARIO 1

SCENARIO 2

SCENARIO 3

18  

£7,232,927.74. Then, the company would have to buy the difference in Reais between the

Beta and the P* (R$28,302,268.53 - R$ 10,950,029.68) = R$ 17,352,238.85 at the spot of

£0.2626/R$, costing £4,556,697.92. Thus, the net flow would be £7,232,927.74 -

£4,556,697.92 = £2,676,229.82

If the scenario 3 occurs and the exchange rate turns out to be £0.2912/R$, and the

stock price value is R$21.00, the WiFindMe Company should not exercise the option

contract. The company would pay the premium of £199,247.97, and sell the R$12,316,584.00

at the market for the exchange rate of £0.2912/R$, totalizing an amount of £3,387,341.29.

Swaps

According to the article written by Bodie and Merton the “swap contract consists of

two parties exchanging (or ‘swapping’) a series of payments at specified intervals over a

specified period of time”. Merton also specifies that the size of each swap payment is “the

difference between the actual value of the item specified in the contract and the value

specified in advance in the contract.” (Bodie and Merton, 2002).

As explained above, a swap contract involves periodic payments and/or cash flows. As

the payment agreement between WiFindMe Company and BRMalls was consisted in 60%

cash down, 30% after 3 months, and 10% in stocks, there is no periodic payments and/or cash

flows. For this reason, swap is not the best way to hedge this transaction.

Conclusion

The transaction between WiFindMe Company and BRMalls has many variables and

risks that the finance sector must evaluate. One of the variables is the hedging method. For

this transaction, the company should hedge against the volatility of the exchange rate between

the real and the pound. To minimize the risks the WiFindMe Company should use two types

of hedge, one for the 30% payment 3 months from the signature of the contract, and one for

the 10% payment in stocks.

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To facilitate the visualization of the different methods of hedging and each result, the

table 1 in the next page shows all the options to hedge against the transaction exposure of the

30% payment. The expected net flow take into consideration the probabilities of each scenario

of the forward exchange rate, that is 25% chance to the forward exchange rate be £0.2481/R$,

25% chance to be £0.2626/R$, and 50% chance to be £0.2912/R$.

By evaluating the table below, it is possible to notice that the best outcome would be if

WiFindMe Company hedge the transaction using an option contract, because, taking into

consideration the probabilities of each forward exchange rate, the company could have an

expected profit of £9,039,791.31. The second best form of hedge, when looking the expected

net flow would be remaining unhedged, however, it is necessary to remember that this is only

an expected net flow. Thus, if the company remains unhedged, it will be assuming the risk of

only getting £8,150,099.52 if the forward exchange rate turn out to be £0.2481/R$.

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Table 1

UNHEDGE FORWARD HEDGE MONEY MARKET HEDGE OPTION HEDGE

Procedure

Don’t hedge against the changes in the exchange

rate.

After 3 months, change the amount received of R$ 32,850,058.50 at the

forward exchange rate.

Sign a forward contract to sell R$ 32,850,058.50 in

exchange of Pounds at the forward rate of

£0.2626/R$

Borrow R$ 32,004,094.28 Buy pounds at the spot of £0.26964/R$, generating

£8,629,583.98. Invest in U.K for 3 months

(0.1247%). Collect the receivable R$ 32,850,058.50 and pay principle plus interests. Receive the investment

made in UK £8,640,345.07.

Sell an European put option to sell R$

32,850,058.50 at the strike price of £0.2626/R$, paying a premium of

£63,350.25

Scenarios Forward rate of £0.2481/R$ £0.2626/R$ £0.2912/R$

Forward rate of £0.2626/R$ Spot £0.26964/R$

Forward rate of £0.2481/R$ £0.2626/R$ £0.2912/R$

Possible Net flow £8,150,099.52 £8,626,425.36 £9,565,973.04

£8,626,425.36 £8,640,345.07

£8,576,994.82 £8,576,994.82

£9,502,587.79 (does not exercise the option)

Expected Net flow (assuming the

probabilities of 25%, 25%, 50% for each

scenario)

£ 8,977,117.74 £8,626,425.36 £8,640,345.07 £9,039,791.31  

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For the 10% payment, WiFindMe Company has the possibility to remain unhedged or

to sign an American put option contract to hedge itself against the variation on the exchange

rate and on the stock price. The two possibilities are shown in the table below:

Table 2 UNHEDGED OPTIONS

Procedure The company will not hedge against the variation of the

exchange rate neither against the variation of the stock

price.

The company will sing an American put option contract

to sell R$28,302,268.53,at the strike price of

£0.2626/R$, paying a premium of £199,247.97

Scenarios (stock price and exchange rate)

R$ 15.95 and £0.2481/R$ R$ 18.67 and £0.2626/R$ R$ 21.00 and £0.2912/R$

R$ 15.95 and £0.2481/R$ R$ 18.67 and £0.2626/R$ R$ 21.00 and £0.2912/R$

Possible Net Flow £2,320,910.70 £2,875,477.79 £3,586,589.26

£2,532,045.61 £2,676,229.82 £3,387,341.29

Expected Net flow (assuming the probabilities of 25%, 25%, 50% for each scenario)

£3,092,391.75

£2,995,739.50

As showed in the table above, taking into consideration the probabilities of each

scenario happing (25%, 25% and 50%), WiFindMe Company would have better results if the

company remains unhedged. This occurs because the cost (premium) for an American put

option is too high, and that would lower the end result (profit) for the company. However, it is

important to remember that as the company is remaining unhedged, there is a possibility of

25% of the forward exchange rate and the stock price be less than what was expected. Thus,

the company can only earn £2,320,910.70, instead of £3,586,589.26, if the stock prince and

the exchange rate turn out to be the best positive scenario.

As already mentioned, the cost of the premium of an American option is higher than

an European option. Thus, as a way to minimize the premium, The WiFindMe Company

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could sign an European put option contract to sell the stocks in the Brazilian market, because

doing this, the company would have a determined date and value to sign an European option

contract. This would make the premium lower, and the company would be hedged against any

variation in the exchange rate. There are put contracts available for the stocks of BRMalls in

the Brazilian stock market.

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Works Cited

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“BACEN SELIC rate, Brazilian central bank’s interest rate.” Global-Rates.com. Treami

Media BV. N.d. Web. 19 Apr 2014.

Bodie, Zvi, and Robert C. Merton. “International pension swaps.” Journal of Pension

Economics and Finance 1.1 (2002): 77-83. Web. 26 Apr 2014.

Eun, Cheol S., and Bruce G. Resnick. International Financial Mgmt 6E. Tata McGraw-Hill

Education, 2012. Print.

Grant, Dwight. “Market index futures contracts: Some thoughts on delivery dates.” Financial

Analysts Journal (1982): 60-63. Web. 26 Apr 2014.

Karatzas, Ioannis. “On the pricing of American options.” Applied Mathematics and

Optimization 17.1 (1988): 37-60. Web. 26 Apr 2014.

Picardo, Elvis. “The Money Market Hedge: How It Works”. Investopedia US, A Division of

IAC. 2014. Web. 29 Apr 2014.

“Why Invest in Brazil.” ApexBrasil - Brazilian Trade and Investment Promotion Agency.

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Wong, Kit Pong. “Cross hedging with currency forward contracts.” Journal of Futures

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