TCAS case

Questions to consider:

1. FX forecast.

2. Financial needs of TCAS

3. Real mark-up on the bid? Was the use of spot rate the correct approach?

4. Alternatives for the hedge? Which one?

Issues with the FX rate

Ways of forecasting FX rate, given the data in the case:

1. BOP data2. IRP3. PPP4. Government policies

Use of the BOP data

The BOP data is provided in exhibit 3. Important factors to be examined:

1. GDP growth2. Inflation3. Government deficit4. Gross savings5. Investments6. Current account7. Capital account8. ST/LT interest rates

Relationship between GDP and FX rate

The greater the "real" growth rate, the greater the potential for income growth, higher interest rates (real), and higher income and investments.

All these should lead to an appreciation in the base currency

Relationship between Remaining factors and FX rate

Inflation and FX rate---NegativeGovernment deficit---NegativeSavings---Positive to neutralInvestments---PositiveST/LT interest rate (real)---positive

Details on "settlement" and FX rate

"Settlement" is the difference between the Current and Capital account. The relationship between the two is almost perfectly negative.

The FX forecasting from BOP examines the Settlement issue. There are three possibilities for this account:

1. Zero (no pressure)--S=D2. Less than zero (negative pressure) S>D3. Greater than zero (positive pressure)S<D

In the latter two cases the outcome is far from certain.

For example, if "less than zero", use of FX reserves and or intervention using trade policies.

Possible scenarios from combination of BOP elements

1. Settlement less than zero, country inflation is higher than other's; domestic real rates lower than the partner's; currency should depreciate

2. Settlement is in deficit; inflation lower; real rates lower; FX rate should depreciate

3. Settlement positive; Inflation lower; Real rates higher; Strong appreciation

4. Settlement positive; inflation higher; Real rates higher' Appreciation.

The bid

Mark-up = 5%

Uses Spot rate to get the bid price

10% collection in May, rest in August

No factor for changes in FX rate was included

Included in the bid was development expense of $300K

Quantitative Analysis

Forward contract

C$2.6M/1.3653 = $1.911M

Foreign currency loanC$ loan amount: C$2.6M/(1+(.1250/4)) = C$2.53M

Less arrangement fee: C$ 0.03125M

Net Loan C$2.53-0.003125 = 2.527M

Convert into $:

C$2.527/C$1.3594 = $1.859M

Opportunity cost of $ debt: $1.859*(1+(.11/4)) = $1.910M

Write a call on C$ at strike of $0.72 (C$ equivalent of 1.39)

Premium received: 0.0356*C$2.6M = $92916

Best case analysis

C$2.6M*(0.72+0.0356) = $1.972M

Break-even rate with the forward rate

(1/1.3653) - 0.0356 = $0.6969

Buy a Put on C$- Strike price of $0.72

Premium paid = 0.0225*2.6M = $58725

Worst case:

C$2.6M*(0.72 - 0.0025) = $1.82M

Break-even with forward rate = (1/1.3653) +0.0025 = 0.755

Conclusions thus far

If expect the spot rate to > 0.755, buy a put

If between 0.6969 and 0.7566, write a call

If less than 0.697, sell forward

Futures contract

C$2.6M * 0.735 - 1300 = $1.917M

Pre-sale of contract

Loan amount: C$2.6M/(1+(0.092/4)) - C$2.55M*0.005 = C$2.538M

Translate into $: C$2.538M/1.3594*(1+(.11/4)) = $1.918M

Tunnel forward

Best case: 2.6M*0.7533 = $1.966M

Worst case:2.6M*0.7133 = $1.861M

Summary of Advantages/Disadvantages

AD Disadvantage

Forward Certaninty Locked

Easy execution Credit facilityBudgeting;Planning

MM hedge As above LockedDocuments

Futures Forward not allowed Not tailoredAdm costBasis risk

Options Flexibility

Unlimited gains Premium

Range-TunnelForward Low cost option Limited

upside

Year Current Capital Settlement Expected results Expected1990 -20.7 23.2 2.5 Appreciate1991 -23.6 22.1 -1.5 Depreciate1992 -21.4 16.8 -4.6 Depreciate1993 -22.3 22.9 0.6 Neutral1994 -16.3 12.3 -4 Depreciate1995 0

Parity Conditions

89 90 91 92 93 94FX rate 1.18 1.167 1.15 1.21 1.29 1.366InflationCanada 4.8 5.6 1.5 1.8 0.2U.S. 5.4 4.2 3 3 2.6Difference -0.6 1.4 -1.5 -1.2 -2.4PPP 1.1773 1.18 1.13 1.19 1.26

Interest rateCanada 0.13 0.09 0.67 0.05 0.54U.S. 0.075 0.05 0.03 0.03 0.042Diff 0.055 0.04 0.64 0.02 0.498IFE 1.2446 1.21 1.18 1.23 1.305Real ratesCanada 0.082 0.03 0.05 0.03 0.052U.S. 0.021 0.01 0 0 0.016Diff 0.061 0.02 0.05 0.03 0.036IFE 1.117 1.14 1.1 1.17 1.246

Ratio analysis

Current 0.67Quick 0.62Cl/TL 0.7ST debt/LT 1.31D/E 1.06Average collection 85

Bid analysis

Bid Components Nature

Design Soft costMaterials Hard costLabor Hard costShipping Hard costDirect Overhead Hard costIndirect Overhead Soft cost