Exchange Rates

Westwood Plastic Inc.

This case would help us to understand and quantify risks (income and cash flow) associated with exchange rate fluctuations. We will examine the use of some instruments available to manage exchange rate risk by using forward contracts, and call and put options.

Questions:

1. Why is Chang concerned about currency rate fluctuations?

2. Calculate the impact on cash flow (in terms of Canadian dollars for meeting Euro expenses) and Net Income before tax (how the ‘net income before tax’ figure would change) of a changing value of the Canadian dollar exchange rates of 1.3336, 1.3536, 1.3736, 1.3936 and 1.4136. Show the impact on cash flows graphically (x-axis: exchange rate; y-axis: changes in cash flow).

3. What is the break-even exchange rate for which the company would violate the loan covenant?

4. Based on the limited information provided in the newspaper article (see case exhibit 2) and in the case, do you believe that the dollar will fall or rise?

5. Evaluate numerically the impacts of both a call option purchase strategy and a forward contract purchase strategy. Use average call premium value from Exhibit 4 for call option strategy and offer rate for the forward contract strategy.

6. What are the net benefits (net of costs) for two strategies (as presented in question 5) for different exchange rates (you can use exchange rates presented in question 2 and add few more)? Show the results numerically as well as graphically (x-axis: exchange rate; y-axis: net benefit (net of costs)).

7. What will be the cash outflow in order to take care of Euro component of expenses (see Exhibit 3) using two different strategies (as presented in question 5) for different exchange rates?