FX RISK HEDGING AT EADS Case Solution
If the management wants to still work based on speed grid then it should look into the disadvantages of speed grid. First, in the extreme cases the functioning of the Speed Grid is not appropriate for EAD is hedging policy. One of the reasons for this is the gap between the total amount of the eligible exposure and the hedge book of the company as the amounts of hedging according to speed grid model is too low. The second disadvantage is the response of the speed grid approach to reverse the exchange rate movements. For instance, when the rate of dollar increases with a higher magnitude than the dollar to euro forward rate, then this leads to higher speed of hedging, which makes this model insignificant especially in the conditions of constantly increasing dollar?
Reasons for which EAD feels Squeezed
The management of EADS feels squeezed for a number of reasons. The number of the total orders has reached to 250 billion between 2005 and 2007. Once, A350 and A380 are launched in the market, this number is expected to increase more. The management of EADS had created a strong reputation in the market. So the demand for Airbus had increased significantly. This means increased revenue would also increase the foreign exchange exposure faced by the company(Allayannis, 2001).
The total exposure of EADS had reached a level of $94.2 billion in the year 2008 and it has been predicted that by the end of 2008, this exposure would increase further by $ 49 billion, which is quite huge. This was the time when the dollar was declining and the FX environment was becoming more complex. During this time, the dollar to euro exchange rate had depreciated from $ 1.2 per euro to a level of $ 1.47 per euro. The management was more pressurized and squeezed to deal with this exposure as this decline had only occurred within the first quarter of the year 2008. Management expected to receive 25% less of euro against each dollar invested.
Another factor due to which the management felt highly squeezed was because the implied volatility of dollar against the euro had increased from 7% to 11% as in exhibit 11 of the case. The management felt more squeezed and depressed when the stock price of EADS had fallen from a high level of 21.8 euro per share to 15 euro per share resulting in a 31% drop in the share price as shown in exhibit 12 of the case. All of these factors had pressurized the management of EADS to make certain policy changes and design a new hedging system for the company.
Quantitative Analysis of Hedging Options
First, the management of EADS will have to determine the total amount of the foreign exchange exposure which is currently faced by the company.Which is eligible for hedging. We have been provided with the hedge ratios in exhibit 8 of the case. The eligible exposure for the company over the next four years has been calculated based on these ratios for the forward, and options hedge alternatives. The foreign exposure, which needs to be closed, is shown below:
The financial analysis of both of these options has been performed in the excel spreadsheet, which is analyzed below:
The hedge ratios, which have been assumed for the forward contracts, are higher because the management of EADS would be locking in the most favorable exchange rates, whereas the initial hedge ratios for the options alternative has been assumed to be 50% and then it has been increased over the years. Based upon the total eligible exposure, the average dollar to euro exchange rate has been computed and the respective gains and losses have been calculated as shown in excel spreadsheet. If the management of the company uses the forward exchange contracts then it would be able to lock in the most favorable exchange rate to receive Euro in future(Bartram, 2012).
However, EADS will have to be cautious with this approach and accurately predict the future exchange rate as there is high risk of the dollar growth. This would result in the prevailing delivery exchange rate over the future exchange rate and huge losses would be incurred after conversion. Moreover, the hedge exposure is quite high now and it would be difficult to find the counter parties to hedge such as huge exposure. If the company finds such counter parties, huge expenses would be required, monitoring and evaluating the credit default risk.
The second option for the company is to make use of the options contract to hedge the 291 million euro exposure. Two different computations have been performed for the options. Firstly, we have assumed the implied volatility to be 11% as stated in the case and under the second computation, we have used the assumptions stated by Mr. Pons and used an implied volatility of 0%. Under the options, the management of EADS in front office can decide that whether it is beneficial to exercise the options depending on whether the delivery exchange rate prevails the spot exchange rate(Papaioannou, 2006).
This option would be beneficial when the dollar is instable. In addition to this, the options contracts would also allow EADS to escape from the unfavorable market-to-market, which would be faced by EADS in case of the forwards contracts. This would also be beneficial for the company from the counter party’s perspectives because it would minimize the default risk of the company. Banks get more profits as they get option premiums thus they would be more willing to offer extra options(Deventer, 2004). However, it should be noted that options are very expensive. According to the exposure, the total premium cost of the company to hedge its exposure of $ 460 billion would be equal to the EBIT of Airbus in 2007. The company might invest this huge cash in other strategic initiatives, which can compensate for the losses on currency exposure…………………………..
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