Question

Suppose that you are part of the Management team at Porsche. Suppose that it is the end of December 2019 and a novel coronavirus that causes a respiratory illness was identified in Wuhan City, Hubei Province, China. The illness was reported to the World Health Organization and there is heightened uncertainty around the Globe. You (as part of the management team) are reviewing Porsche’s hedging strategy for the cash flows it expects to obtain from vehicle sales in North America during the calendar year 2020. Assume that Porsche’s management entertains three scenarios:

Scenario 1 (Expected): The expected volume of North American sales in 2020 is 35,000 vehicles.

Scenario 2 (Pandemic): The low-sales scenario is 50% lower than the expected sales volume.

Scenario 3 (High Growth): The high-sales scenario is 20% higher than the expected sales volume.

Assume, in each scenario, that the average sales price per vehicle is $85,000 and that all sales are realised at the end of December 2020. All variable costs incurred by producing an additional vehicle to be sold in North America in 2020 are billed in euros (€) and amount to €55,000 per vehicle. Shipping an additional vehicle to be sold in North America in 2020 are billed in € and amount to €3,000 per vehicle.

The current spot exchange rate is (bid-ask) $1.11/€ - $1.12/€ and forward bid-ask is $1.18/€ - $1.185/€. The option premium is €0.025, and option strike price is €0.922. Your finance team made the following forecasts about the exchange rates at the end of December 2020:

• bid-ask will be $1.45/€ - $1.465/€ if the investors (and speculators) consider the euro (€) a safe haven currency during the pandemic.

• bid-ask will be $0.88/€-$0.90/€ if the investors (and speculators) consider the U.S. dollar ($) a safe haven currency during the pandemic

5. Assume that the Scenario 2 (Pandemic) took place in 2020 and the U.S. dollar became a safe haven currency during the pandemic. What are your cash flows (profits) if you did not hedge, hedged using forward contracts, and hedged using option contracts?

6. Based on the calculations in Part B, do you believe that it is a good policy to hedge Porsche’s currency exposure? Why?

Answer 1

Avg. Sales Price per vehicle = $85,000

Variable Cost = €55,000

Shipping cost = €3000

Current spot exchange rate is (bid-ask) = $1.11/€ - $1.12/€ = avg of bid and ask = $1.115/€

forward bid-ask = $1.18/€ - $1.185/€ = $1.1825/€

option strike price = €0.922

option premium = 0.025 * €0.922 = €0.02305

Euro (€) a safe haven currency = $1.45/€ - $1.465/€ = $1.4575/€

U.S. dollar ($) a safe haven currency = $0.88/€-$0.90/€ = $0.89/€

Expected final sales volume is 35,000

5)U.S. dollar a safe haven currency

Total sales of vehicle = 50% * 35000=17,500

Revenue = 17500*$85000 = $1,487,500,000

Revenue with no hedge = $1,487,500,000/$0.89/€ = €1,671,348,315

Revenue with hedge using forward contracts = $1,487,500,000/$1.1825/€ = €1,257,928,118

Revenue with hedge using option contracts = $1,487,500,000/(€0.922+€0.02305)= €1,573,990,794

6)It is always better to have a hedged position because volatility of exchange rate is very high and can result in a significant amount of loss in cashflow