The time now is mid-November 2016. Seatle Inc. and Graham Ltd are two export companies, both based in Chicago, USA. They both have income and payments in foreign currencies. The two companies have never hedged their exposures and the two CEOs know each other fairly well. This year, the new CFOs at both companies are recommending using hedging strategies to protect their foreign exchange and interest rate exposure. Below is information of the two companies: SEATLE INC: It exports to Japan and receives payment in Japanese yen (JPY), averaging 50mio JPY every 3 months (March, June, September and December).

It has a borrowing of 1,000,000USD from a US bank and currently pays a floating rate of LIBOR + 2.5% (USD LIBOR one month rate) every month. The CFO is of the idea of converting this to fixed rate payment because he believes that LIBOR rate may go up.

It needs to pay to suppliers in Mexican Peso (MXN) averaging 5 million MXN every 3 months (March, June, September and December).

GRAHAM LTD:

It imports from China and needs to pay 5,000,000 yuan (CNY) every month to Chinese customers (the next payment will be due in December 2016). Every month from now till the end of 2017 it collects 200,000CAD as payment of a contract obligation that it has performed earlier in 2016. The next collection is in December 2016.

The company sells goods to Mexican customers and expects to receive 5 million MXN every 3 months (March, June, September and December). It borrows 1,000,000USD from a US bank and is currently paying a monthly fixed rate of 3.65% per annum. The new CFO is of the view that the company should pay a floating rate as he believes interest rate will come down.

Both company has relationship with WELL FARGO BANK in the region which sell certain forwards contract. They also know Mr. GEORGE S., who is a speculator and arbitrageur in the market.

The current exchange rates (spot rate):

1MXN = 0.07 USD (1 USD = 14.286MXN)

1JPY = 0.008849USD (1USD = 113 JPY)

1CAD = 0.8 USD (1USD = 1.25CAD)

1CNY = 0.1443 USD (1USD = 6.93 CNY)

Current LIBOR USD 1 month rate is 0.53817% The two companies have obtained information about foreign exchange futures from the Chicago Mercantile Exchange as attached in Appendix 1. They have also make inquiry with both Well Fargo Bank and Mr George S. and was given the following information: WELL FARGO BANK is willing to sell the following forwards of USD with amount up to 1 million USD equivalent (maximum) at the following rate and maturity: Rate Maturity 1USD = 1.37CAD Dec 2016

1USD = 109 JPY Dec 2016

1 USD = 6.84 CNY Mar 2017

1 JPY = 0.067 CNY Dec 2016

1 CAD = 16.58MXN Dec 2016

MR. GEORGE S. is willing to sell the following options: Type Rate Premium Expiry

Call on MXN $0.0588/MXN $0.0006/MXN DEC 2016

Put on CNY $0.1330/CNY $0.0005/CNY DEC 2016

Call on CAD $0.8705/CAD $0.0007/CAD MAR 2017 Additional Information: 30-day investing/borrowing Japanese yen: 0.70% / 1.40%

120-day investing/borrowing Japanese yen: 0.75% / 1.55%

30-day investing/borrowing Mexican peso: 5.25% / 5.75%

120-day investing/borrowing Mexican peso: 5.45% / 5.90%

30-day investing/borrowing Chinese yuan: 4.55% / 4.80% 120-day investing/borrowing Chinese yuan: 4.65% / 4.90% 30-day investing/borrowing rate Canadian dollar: 0.60% / 1.40% 120-day investing/borrowing rate Canadian dollar: 0.63% / 1.43%

Seatles cost of capital: 8.33% Grahams cost of capital: 9.13%

Additional information (added March 20, 2018): Investing/borrowing rate in USD for both companies: 3.15%/3.65%

Questions:

1.) What are the exchange rate risk and interest rate risk faced by Seatle Inc. and Graham Inc? (7.5 marks)

2.) If they decide to use the futures, forwards, options and swaps to hedge their exchange rate and interest rate risks, given the data in the questions, outline at least 2 strategies, explain them in details. (Note each strategy should outline hedging all of the exposures if possible, not only one exposure. If you use options, draw the profit payoff chart.) (22.5 marks)

3.) What do the futures, forwards and options tell you about the markets forecast of future exchange rate? Explain your reasoning. (8 marks)

4.) Calculate the payout of your two strategies proposed in question 2 if in December 2016 the spot exchange rate as follows:

1 USD = 20 MXP

1 USD = 108 JPY

1 USD = 1.25 CAD

1 USD = 6.71 JPY

LIBOR USD 1-month: 0.89% 4.) Are Seatle Inc and Graham Ltd better off hedging or not hedging? Which strategy do you recommend for each company? (12 marks)