Voyages soleil case study.xlsx

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THE HEDGING DECISION

VOYAGES SOLEIL

Team iThinkersArindam Routh

Rajib LayekSinjana Ghosh

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Case in hand

VS is a leading Canadian tour operator with a sales growth of roughly 50% from 1997 to 2001

There was a sudden drop in its demand after the 2001 terrorist attack on US which hit both its top-line as well as bottom-line growth

Clients pay in CAD, but vendors only accept USD - VS vulnerable to Foreign exhange risk

April 1, 2002 deadline for VS to decide on its hedging strategy for US$60 million in payables due October 2002

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Macro-economic Outlook

CAD depreciating against the USD since 1998 Canadian GDP reported to be 2.4% in March 2002Canadian dollar depreciates against US dollar

despite strong GDP growthDecline in interest rates in both US and CanadaHigh volatility in exchange rate and Canadian stock

market

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Industry Analysis

Pre-Sept 11, 2001 scenario: High growth industry, with greater than 8% growth

rate from 1998 to before Sept 11, 2001 Sales were positively correlated with GDP growth

Post-Sept 11, 2001 scenario: Post Sept 11, 2001 attacks the Canadian trips to US

declined by 25%, and to Florida and Mexico declined by 15% and 12% respectively

2 out of 7 Quebec’s operators declare bankruptcy Top-line growth of the tourism industry declines

between 30% and 50%

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Issues to be addressed

Bottom-line growth: Transaction exposure: gains or losses that arise from the

settlement of existing financial obligations the term of which are stated in a foreign currency. Arises from the payables denominated in USD (foreign exchange risk)

Solution: Hedging- Making an investment to reduce the risk of adverse price movements

Top-line growth: Trips declined, sales gone down Solution: Geographical diversification (Australia, APAC, Europe)

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Alternatives for Dupuis

Alternative 1: Do nothingAlternative 2: Hedge by using Forward

ContractAlternative 3: Borrow CD$ and invest in US$

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Alternative 1: Do nothing

Wait and exchange Canadian dollars in October at the prevailing spot rate ($.6298 US = 1 CD) at that time.

No change in spot rate (payment $95.27 million)

CD depreciates (payment > $95.27 million)

CD appreciates (payment < $95.27 million)

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Sensitivity Analysis

Scenario 1 - Canadian dollar depreciates in the next 6 months

Ex-Rates (US$/Cdn$) 0.6298 0.6200 0.6150 0.6100 0.6050 0.6000

A/P in US$ (million) 60 60 60 60 60 60

A/P in Cdn$ (million) 95.27 96.77 97.56 98.36 99.17 100.00

Scenario 2 - Canadian dollar appreciates in the next 6 months

Ex-Rates (US$/Cdn$) 0.6298 0.6396 0.6446 0.6496 0.6546 0.6596

A/P in US$ (million) 60 60 60 60 60 60

A/P in Cdn$ (million) 95.27 93.81 93.08 92.36 91.66 90.96

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Alternative 2: Hedge by using Forward Contract

Six month forward rate was $.6271 US = 1 CD or 1.59 CD = $1 US

1.59CD/$US * $60 million US = 95.68 CD (locked assuming that the six month forward rate holds)March

2002US Canada

Interest rate

2.55% 1.65%

Inflation rate

1.785% 1.15%

Method Formula Projected rate

IFE 0.6354

PPP 0.6337

Under IFE and PPP Canadian dollar is expected to appreciate

S1/0.6298 = (1+0.0255)/ (1+0.0165)

S1/0.6298 = (1+0.01785)/ (1+0.0115)

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Alternative 3: Borrow CD$ and invest in US$

Need $60 million US$ and receive 1.65% from investing in US $ or (.825% for 6 months)

1.00825x= $60 million US x = $59.51 million US (How much to invest)

Convert back to CD$ (.6298US$/CD or 1.5878CD/US$)

$59.51 million US * 1.5878CD/US$ = 94.49 CD

Figure out payment - Cost you to borrow 2.7% interest (1.35% for 6 months)94.49 CD *1.0135 = 95.76 CD (what you need to borrow in CD )

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Evaluating Alternatives

Alternatives

Decision Criteria

Cost Result / Benefit Risk

1. Do Nothing None unpredictable

Scenario 1: = $95.27 Million

Scenario 2: >$95.27 Million

Scenario 3: <$95.27 Million

High

2. Hedge via Forward Contract

Low

(Need LOC)

Payment = $ 95.68 Million None

3. Borrow CD$ and Invest in US$

High

(WC Stuck)

Payment = $ 95.76 Million High (interest rate and forex)

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Recommendation

Alternative : 2 (As per case)Alternative : 4 (Option)

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A CASE ON: FANNIE MAE

Financial Shenanigans in Derivative market

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Incentive from a fraud.

Companies with healthy businesses can engage in income-smoothing shenanigans to give the illusion of nice, steady, predictable results.

Desire to portray very smooth earnings despite a period of volatile interest-rate movements.

Management also had a strong desire to achieve profit targets that would trigger maximum bonuses

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Need for Derivative

Fannie Mae’s business is subject to a substantial amount of interest-rate risk, and the company therefore used derivatives extensively to manage this risk.

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Accounting Rules for derivative

Accounting rules for derivatives (SFAS 133) provide a framework for categorizing hedges into groups based on different attributes, such as their purpose and effectiveness.

The categorization is important because it determines whether or not fluctuations in the derivative will affect earnings.

For example, all quarterly gains or losses from the change in value (i.e., the mark-to market adjustment) on a hedge that is deemed to be “ineffective” should be recognized as current-period income. Yet for certain types of “effective” hedges, the change in value does not affect earnings at all.

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The Fraud

Disregarding hedge accounting rules by valuing and categorizing its hedges inappropriately.

In a nutshell, Fannie did not record declines in the value of its derivatives appropriately; it classified some hedges as effective (no impact on earnings) when they should have been treated as ineffective (impact on earnings).

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Continue…..

This trick allowed Fannie to continue its smooth earnings by giving management the discretion to take gains and losses on derivatives in whatever period it saw fit.

In fact, Fannie’s unreported derivative losses totaled $7.9 billion.

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Learnings

Accounting rules (SFAS 133) require that derivatives be marked to market each quarter. The mark-to-market adjustment(i.e., the change in fair value) is generally reported as earnings (or loss) in the current period, unless the derivative is being used as an effective cash flow hedge on a future transaction.

If a derivative is being used to hedge an asset or a liability effectively, the value of the hedge will move in the opposite direction from the value of the asset or liability.

As a result, quarterly fluctuations in fair value on certain types of effective hedges do not affect earnings

Mahindra and Mahindra

DERIVATIVE CONTRACT ANALYSIS

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Past failures in hedging

FY 2009: EBIT margin( by 300 bp)hit due to loss on account of forex fluctuations worth Rs. 182 crores.Adjusted with this EBIT stood at Rs.155crore, 42% lower than the profit reported in the year-ago quarter.

“While the forex loss can be treated as an exceptional item, it’s important to note that nearly three-fourths of the loss, or Rs136.5 crore, wasn’t a notional or mark-to-market loss but an actual cash loss borne by the company when it cancelled forward contracts in the currency derivatives market. This amounts to about 75% of the pre-tax profit the company generated last quarter, and is a case of an aggressive hedging policy backfiring”- Mint report Feb 2009

Source: Q3 FY09 Analyst Call Transcript, http://www.livemint.com

Growth in Foreign exchange hedging

Source: Mahindra and Mahindra Annual Reports

200920102011201220130

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40

60

80

100

120

Foreign exchange Contracts

Foreign ex-change contracts

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Derivative portfolio

Derivative portfolio 2009

Forwards Contracts USDRange forwardsPlain vanilla put optionsDerivative in form of "strips"



Source: Mahindra and Mahindra Annual Report 2010, 2011

Derivative portfolio

Portfolio 2012








Interest Rate Risk

During FY’11 and FY’12, the company subscribed to bonds of Ssangyong Motor Company limited: 9540.48 crores KRW

The Company hedged the interest rate and foreign exchange risk by forward contracts (details not disclosed)


Derivative instruments and Hedge accounting

Uses forwards and currency options to hedge its risks associated with foreign exchange rate and highly probable forecast transactions

Hedge accounting principles Accounting Standard 30: “Financial Instruments: Recognition and Measurement”.

So mark to market price is used for reporting derivatives in consolidated financial statements

Changes in the fair value(M2M) of the contracts that are designated and effective as hedges of future cash flows are recognized in Hedging Reserve Account and ineffective portion is recognised in P/L statements

Source: Mahindra and Mahindra Annual Report 2013

Final comments

Uses derivatives only for hedging and not for speculation

Hedges mainly to reduce foreign exchange risk

However a large amount of foreign exposure is unhedged as follows: Receivables: ZAR 3.8 crores, USD 2.81 crores, AUD

0.8 crores, GBP 0.24 crores, AED 0.02 crores Payables: JPY 4.83 crores, EUR 1.2 crores, SEK 0.06

crores, and other currencies under 50000


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