Nicoll Corporation

Nicoll Corporation is a large firm with its headquarters based in Chicago, Illinois. The company specializes in designing and building large special order items. Over the last few years, the company has begun to make bids on projects located outside of the United States. They have been very successful in these bids as much time is spend on estimating all of the costs of the project.

Nicoll Corporation recognizes that certain risks are incidental to normal operations. However, the company's general philosophy is to avoid unnecessary risk and to limit, to the extent practical, any risks associated with business activities. Since the firm's functional currency in the U.S. dollar and the bid must be submitted to the potential client in its own local currency, the firm has begun hiring an outside CPA/Financial Engineer to advise their CEO, Derek Nicoll, on how to manage the foreign currency risk associated with the bid.

Nicoll Corporation is biding for a contract to manufacturer items for a large construction firm in Hamburg, Germany. The Bid must be submitted in deutsch marks. Nicoll plans to make a bid of 40M DMs. At today's spot market price the bid is U.S. dollars is equivalent to 40,000,000 x .5488 =$21,952,000. (To check out today's exchange rates.) Once the bid is submitted, Nicoll must be prepared to accept the 40M DM if the bid is successful. Since the firm's functional currency is the U.S. dollar, it will convert the DM into dollars at whatever the current spot rate is on the date payment is received for the project. If the DM weakens, Nicoll will receive effectively less U.S. dollars. (To simplify the situation, assume Nicoll will receive a lump sum payment on January 15, x2 if awarded the contract.)

Development of Currency Financial Instruments

Each country has its own designated currency. In the United States it is the dollar, in Japan the yen, and in Germany the deutsche mark. To settle transactions among individuals, corporations, and governments, there is a rate at which currency from one country can be converted into the currency of another. That rate is called the exchange rate. Initially the exchange rates for the U.S. dollar was fixed against most other currencies. But in 1972, the United States changed to a floating exchange rate. Today, most country's currencies are based on a floating rate. (Note - this may change with the implementation of a unified currency -- the Euro for the European Union.)

As foreign business activity has expanded, the financial world has developed derivative instruments to help individuals, businesses, and governments, reduce the risks of exchange rate fluctuations. The Chicago Mercantile Exchange, during the transition to freely floating exchange rates, established the International Monetary Market for the trading of future contracts in foreign currencies. These were the first financial futures contracts. Similar, in "concept," to a futures contract is a foreign currency forward contract. They too have existed in the U.S. for a long time, but unlike the futures market, no physical facility exists for trading. Forwards trade strictly in over-the-counter markets and are usually arranged among major financial institutions. The size of the market is unknown, as the terms of the contracts are private and unregulated. The transaction sizes are quite large and the terms and conditions of the contract are tailored to meet the specific needs of the two parties. The two parties essentially agree to the trade and accept the credit risk of their counter-part to the contract. A fee is paid to the bank for arranging the forward contract.

Link to chart on Foreign Currency Futures Volume, 1981 - 1993
For Five Major Currencies

An individual that purchases a futures contract, unlike a forward contract, is subject to a daily settlement procedure. In the daily settlement process, investors who incur losses pay them every day to investors who make profits. A futures contract is much more liquid than a forward contract, because the contracts trade on an organized exchange. These contracts have standardized terms. This enables a buyer of a future, the one who has the obligation to buy an item on a future date, the ability to sell the contract and be relieved of all obligations to purchase the item. Likewise, for a seller of a futures contract. Participants in the futures markets must set up a margin account with a broker and maintain an agreed upon daily balance. Participants in the futures market do not have the risk of their counter-party to their contract defaulting, but, as stated before, they must make daily settlement payments to their brokers based upon the days trading activity.

Another instrument that exists is the currency option. Like traditional options, these enable the buyer the right, but not the obligation, to purchase or sell a currency at a later date at a price agreed upon today. These options are available through an organized exchange at fixed amounts and expiration dates as well as in over-the-counter markets. Currency options provide flexibility in hedging situations when their buyers/sellers are unsure of whether they will receive foreign cash flows. A futures call option gives the owner the right, but not the obligation, to buy the underlying futures contract at the option contract's strike price. A futures put option gives the owner the right, but not the obligation, to sell the futures contract at the option contract's stike price. Participants who purchase their options over an organized exchange do not have the risk of their counter-party defaulting; however, all option purchases must be fully margined.

Link to a further discussion on the differences between Forwards and Futures

Link to glossary

LINK TO QUESTIONS

NICOLL's BID

Derek Nicoll, the company's CEO, after discussions with all members of the proposal team, has decided that the bid the firm will submit to the German construction client will be for 40M DMs. It is the middle of November, x1, and the bid must be submitted by December 1^st. Prior to submitting the bid, Mr. Nicoll would like you, a CPA with a good background in derivative instruments to discuss with him the various strategies his firm could use to hedge against fluctuations in the dollar/DM exchange rate.

Nicoll Corporation will find out if its bid has been accepted late December to early next January. Mr. Nicoll has also wondered about the related accounting aspects of the hedging strategy chosen and would like you to prepare for him the journal entries and a brief synopsis of the effects on the income statement and balance sheet based on the various strategies using hypothetical numbers. He knows that you cannot guarantee any outcome, as foreign currency exchange rates are based upon an assortment of factors, but seeing the possible outcomes would help him and the board of directors evaluate the company's exposed risk.

DERIVATIVE ENVIRONMENT

The hypothetical numbers that you will use to walk Dr. Nicoll through the various hedging strategies are listed below. You will assume two possible outcomes of the DM to U.S. dollar spot exchange rate. The first will be that the dollar appreciates against the DM and the second, the dollar depreciates. The rates for the futures, forward, and option contracts were obtained through consulting early April's Wall Street Journal and modifying the dates to fit the case.

Spot rates to use in your assumptions are as follows:

LINK TO QUESTIONS

Link to Teaching Notes

Futures - Currency Contracts:

Deutsch mark (CME) - 125,000 marks; $ per mark

Note the DM change of .0595 over the life of the futures contract. This change shows the risk that is involved in the purchase of one futures contract.

LINK TO QUESTIONS

Link to Teaching Notes

Forward - Currency Contracts:

For simplicity sake, assume that the exchange rates and delivery dates available in the futures market are similar to those that can be obtained through entering into a forward contract negotiated through a large bank.

Link to a further discussion on the differences between Forwards and Futures

Currency Option Contracts:

Deutsch mark (CME) - 125,000 marks; cents per mark

LINK TO QUESTIONS

Link to Teaching Notes

Note: Ideas for the case came from a similar example in Don M. Chance's Introduction to Derivatives book, 3rd edition.