MGT 4070: International Finance Course Instructor: Professor Nishant Dass Midterm Exam 1 17 February 2014

Name: Lee Yao Xin GTID: 903042270

Case Study: Voyages Soleil: The Hedging Decision

Jacques Dupuis, president and owner of Voyages Soleil (VS), faces an important financial decision in determining how he should manage his companys upcoming foreign exchange obligations. This situation arises due to the fact that VS clients paid in Canadian dollars while the hotels in the United States would only accept payment in U.S. dollars. Furthermore, reservations at these hotels had to be booked in April but payment had to be made in October. There were three options being considered: wait and exchange in October; contract forward contracts now; or to borrow Canadian dollars to buy U.S. dollars now and invest them for six months, using the proceeds to pay in October. This case analysis aims to evaluate the options and to present a recommendation with regards to the knowledge and situation at that point in time. Firstly, a brief overview of the economic situation in Canada will be discussed. As a result of the events of 9/11 on the United States, the travel industry, especially air travel, was adversely affected. This can be seen numerically from the statistics that the total number of trips Canadians made to the United States dropped by almost 25 per cent. Specifically, trips by Canadians to Florida and Mexico dropped by 15 and 12 per cent respectively. Part of the decline can also be attributed to the falling value of the Canadian dollar even before 9/11. This downward trend can be observed from Exhibit 2 with the Canadian dollar steadily depreciating against the U.S dollar. A weak Canadian dollar would translate into higher average cost for Canadian tourists and decrease overall consumption in the tour operating industry. Shifting the focus to Quebec, the total volume of the tourism sector declined between 30 to 50 per cent. Consequently, two of Quebecs seven tour operators declared bankruptcy, and the surviving few were competing to attract customers. Minimisation of risk became a huge factor in these uncertain times as companies were unsure of the future demand for tour packages. In deciding which option is best for VS as a whole, two main criteria are employed in the decision making process. Firstly, minimisation of cost is used as this determines the revenue of VS. Secondly, minimisation of risk is used and is especially pertinent in these unpredictable times.

The first alternative available to Dupuis is to wait it out and only exchange for the U.S. dollars at the prevailing spot exchange rate in October. There are three possible scenarios for this option. Firstly, if the spot exchange rate remains at the current value of 0.6298 US$/Cdn$, the total amount in Canadian dollars will be Cdn$ 95,268,339.16 Secondly, if the Canadian dollars were to depreciate below 0.6298 US$/Cdn$, the total amount will be greater than in the first case and vice versa for the opposite case. As seen in exhibits 2 and 5, the general trend for the US$/Cdn$ is to decrease over time. Although these trends are observed in the long term, they can be used somewhat as an indicator of the future short term trend. This notion is also supported in exhibit 7 which clearly shows a downward trend in the PPP exchange rates from the middle of 2001 to the first quarter of 2002. Furthermore, the six-month forward rate is 0.6271 US$/Cdn$, showing that the market expects the Canadian dollar to depreciate. Based on the current outlook for the spot exchange rate in October, it is likely that VS will pay more than Cdn$ 95,268,339.16 The next alternative is to utilise forward contracts to lock in the amount payable to the suppliers. Based on the April 1, 2002 rate of 0.6271 US$/Cdn$, the total amount in Canadian dollars will be Cdn$ 95,678,520.17 This option does not minimise cost but in return has zero foreign exchange risk. The last alternative is to borrow Canadian dollars to exchange for U.S. dollars on April 1, 2002, which are to be invested for six months. Based on the calculations in appendix 1, this will result in Cdn$ 96,252,419.39 payable in October. This option ensures that there is no foreign exchange risk but increases the expenditure of the company. Having discussed all three alternatives, I feel that option 2 presents the best choice given the circumstances. Options 2 and 3 are very similar in that they both eliminate foreign exchange risk. However option 2 is the clear winner as the net amount payable is Cdn$ 573899.2 less, appreciably lower compared to option 3. In comparison, the decision between options 1 and 2 is not as straightforward. On one hand, option 1 minimises cost at the expense of a certain amount of foreign exchange risk. On the other hand, option 2 has zero foreign exchange risk at the expense of (possibly) minimising cost. To resolve this issue, we need to evaluate the potential gains of using option 1. Assuming the spot exchange rate does not change, and assuming all profits go to lowering the prices of tour packages, customers can expect to have a 1.85 per cent decrease in overall price of tour packages. From the perspective of a consumer, this is not a significant enough change in price. The insignificant price reduction combined with the high probability of the Canadian dollar depreciating makes option 2 the better of the two alternatives. Overall, option 2 is the best amongst the three alternatives due to the probable depreciation of the Canadian dollar and the minimising of foreign exchange risk.

Appendix 1 Option 1: Wait and exchange in October

Scenario 1: Spot rate is unchanged in October at 0.6298 US$/Cdn$ Amount paid: (US$ 60,000,000)/(0.6298 US$/Cdn$) = Cdn$ 95,268,339.16

Option 2: Hedge using forward rate Amount paid: (US$ 60,000,000)/(0.6271 US$/Cdn$) = Cdn$ 95,678,520.17

Option 3: Borrow Canadian dollars, exchange for U.S. dollars and invest them Using the Euro-U.S. rate of depositing at 1.65 per cent, USD 60,000,000 = (1+0.0165)(X) X = USD 59,026,069.85 Using the spot exchange rate of 0.6298 US$/Cdn$. Need to borrow => (USD 59,026,069.85)/(0.6298 US$/Cdn$) = Cdn$ 93,721,927.35 Using the Euro-Canadian rate of borrowing at 2.7 per cent, Amount paid: (Cdn$ 93,721,927.35)(1+0.027) = Cdn$ 96,252,419.39

Option 1 vs Option 2 Possible benefit to customers =>

Option 2 vs Option 3 Net difference in amount paid = 96,252,419.39 - 95,678,520.17 = 573899.22