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, China.

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/€ - $1.185/€. The option premium is 2.5% of US$ strike price, and option strike price is $1.085/€. 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

1. You decided not to hedge Porsche’s currency exposure. Assuming that the expected final sales volume is 35,000, what are your total costs
   a) if the exchange rate (bid-ask) remains at $1.11/€ - $1.12/€? Let’s call this the baseline scenario.

   b) if the investors consider the euro a safe haven currency during the pandemic? How does this compare to the baseline case?
   c) if the investors consider the U.S. dollar a safe haven currency during the pandemic? How does this compare to the baseline case?

2. Assume that you and the Porsche’s management team decided to hedge using forward contracts. Assume that the expected final sales volume is 35,000. What are your total benefit/cost and the percentage benefit/cost from hedging (compared to no hedging)
   a) if the exchange rate (bid-ask) remains at $1.11/€ - $1.12/€?

   b) if the investors consider the U.S. dollar a safe haven currency during the pandemic?

3. As the CFO, you decided to hedge using option contracts. Assuming expected final sales volume is 35,000, what are your total benefit/cost and the percentage benefit/cost from hedging (compared to no hedging)
   a) if the exchange rate (bid-ask) remains at $1.11/€ - $1.12/€?

   b) if the investors consider the U.S. dollar a safe haven currency during the pandemic?

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

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 euro cash flows 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

When Management team does not hedge the currency exposure :

a) Total Sales Volume = 35,000 units

Variable Cost = € 55,000 per vehicle

Shipping Costs = € 3,000 per vehicle

Therefore, Total Cost = € 58,000 per vehicle

So, there is currency exposure amounting to € 58,000. The manaagement team has decided not to hedge Porsche’s currency exposure, hence the exchange rate remains at $1.11/€ - $1.12/€.

Total Cost per vehicle in $ = € 58,000 x 1.12 = $ 64,960

Therefore, Total Cost of 35,000 vehicles = 35,000 x $ 64,960 = $ 2,273,600,000.

b) If the investors consider the euro a safe haven currency during the pandemic, the total cost calculation will be as follows :

The exchange rate will be $1.45/€ - $1.465/€.

Total Sales Volume = 35,000 units

Variable Cost = € 55,000 per vehicle

Shipping Costs = € 3,000 per vehicle

Therefore, Total Cost = € 58,000 per vehicle

Total Cost per vehicle in $ = € 58,000 x 1.465 = $ 84,970

Therefore, Total Cost of 35,000 vehicles = 35,000 x $ 84,970 = $ 2,973,950,000.

Hence, as compared to the baseline case, the total cost has increased by $(2,973,950,000 - 2,273,600,000) = $700,350,000.

c)

If the investors consider the US Dollar a safe haven currency during the pandemic, the total cost calculation will be as follows :

The exchange rate will be $0.88/€ - $0.90/€.

Total Sales Volume = 35,000 units

Variable Cost = € 55,000 per vehicle

Shipping Costs = € 3,000 per vehicle

Therefore, Total Cost = € 58,000 per vehicle

Total Cost per vehicle in $ = € 58,000 x 0.90 = $ 52,200

Therefore, Total Cost of 35,000 vehicles = 35,000 x $ 52,200 = $ 1,827,000,000

Hence, as compared to the baseline case, the total cost has decreased by $( 2,273,600,000 - $ 1,827,000,000) = $446,600,000.

Assuming that me and the Porsche’s management team decided to hedge using forward contracts:

a) Total Cost of 35,000 vehicles using $1.11/€ - $1.12/€ = 35,000 x $ 64,960 = $ 2,273,600,000. (from (a) above)

This is the total cost of No Hedging.

Now, the Total cost as per the forward contract =

Forward Rate = $1.18/€ - $1.185/€

Therefore, Total Cost per vehicle in $ = € 58,000 x 1.185 = $ 68,730

Therefore, Total Cost of 35,000 vehicles = 35,000 x $ 68,730 = $ 2,405,550,000

Hence, as compared to the No Hedging, the total cost has increased by $(2,405,550,000 - 2,273,600,000) = $131,950,000.

Answer - As compared to No Hedging, the cost has increased by $131,950,000 &

the percentage increase in cost = ($131,950,000/$ 2,273,600,000) x 100 = 5.80%.

Now, if the investors consider US Dollar as a safe haven currency during the pandemic :

b) The exchange rate will be $0.88/€ - $0.90/€.

Total Cost of 35,000 vehicles = 35,000 x € 58,000 x 0.90 = $ 1,827,000,000

This is the total cost of No Hedging.

Now, the Total cost as per the forward contract =

Forward Rate = $1.18/€ - $1.185/€

Therefore, Total Cost per vehicle in $ = € 58,000 x 1.185 = $ 68,730

Therefore, Total Cost of 35,000 vehicles = 35,000 x $ 68,730 = $ 2,405,550,000

Hence, as compared to the No Hedging, the total cost has increased by $(2,405,550,000 - 1,827,000,000) = $587,550,000.

Answer - As compared to No Hedging, the cost has increased by $587,550,000 &

the percentage increase in cost = ($587,550,000/$ 1,827,000,000) x 100 = 31.67%.