6 Pages Posted: 21 Oct 2008
A small adhesives company faces exchange rate risks as it makes its first foray into international sales. The receipt of payment from an unhedged foreign-currency-denominated past sale illustrates potential currency risks while a potential follow-on order provides a context to discuss potential hedges. Sufficient detailed information is provided for the students to construct and analyze both a forward and money market hedge. A teaching note and instructor and student Excel spreadsheets are available.
Rev. Oct. 19, 2010
In early June 2006, Doug Baker met with his sales manager Alissa Moreno to discuss the results of a recent foray into international markets. This was new territory for Baker Adhesives, a small company manufacturing specialty adhesives. Until a recent sale to Novo, a Brazilian toy manufacturer, all of Baker Adhesives' sales had been to companies not far from its Newark, New Jersey, manufacturing facility. As U.S. manufacturing continued to migrate overseas, however, Baker would be under intense pressure to find new markets, which would inevitably lead to international sales.
Doug Baker was looking forward to this meeting. The recent sale to Novo, while modest in size at 1,210 gallons, had been a significant financial boost to Baker Adhesives. The order had used up some raw-materials inventory that Baker had considered reselling at a significant loss a few months before the Novo order. Furthermore, the company had been running well under capacity and the order was easily accommodated within the production schedule. The purpose of the meeting was to finalize details on a new order from Novo that was to be 50% larger than the original order. Also, payment for the earlier Novo order had just been received and Baker was looking forward to paying down some of the balance on the firm's line of credit.
As Baker sat down with Moreno, he could tell immediately that he was in for bad news. It came quickly. Moreno pointed out that since the Novo order was denominated in Brazilian reais (BRL), the payment from Novo had to be converted into U.S. dollars (USD) at the current exchange rate. Given exchange-rate changes since the time Baker Adhesives and Novo had agreed on a per-gallon price, the value of the payment was substantially lower than anticipated. More disappointing was the fact that Novo was unwilling to consider a change in the per-gallon price for the follow-on order. Translated into dollars, therefore, the new order would not be as profitable as the original order had initially appeared. In fact, given further anticipated changes in exchange rates the new order would not even be as profitable as the original order had turned out to be!
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Keywords: curreny, hedging, finance, international
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