Baker Adhesives (ba) Forex Risk

The original sale (BRL 104,338.30) to Novo once the exchange-rate change is acknowledged on 05/23/06 at a bid exchange-rate of 0.4432 US$/BRL generates a profit of $1,742.73 (3.9% profit margin) versus the original estimate of $3,871.24 (8.7% profit margin) based on the exchange-rate of 0.4636 used in the initial calculation. (Appendix-1)

Had BA entered into a forward contract for 05/23/06, at an exchange-rate of 0.4490 US$/BRL (appendix-2) once the order was placed on 02/23/06, the company would have realized a profit of $2,343.84 (5.3% profit margin) which results in $1,525.73 less than the original calculation instead of their current loss of $2,128.50. BA could have also used other FOREX hedge methods (derivatives) to minimize or eliminate their exposure to foreign exchange risk. FOREX derivatives include: options, forex and currency swaps, and futures.

If BA agrees to the new Novo sale of 1,815 gallons (50% larger than original order of 1,210 gallons) at the same price of 86.23 BRL per gallon; the present value of the expected future cash inflow of 156,502.04 BRL on 09/05/06 assuming:

(1) No hedge: is calculated to be $65,428.50 (based on a forecast bid exchange rate of 0.4234, discounted at an effective rate of 1.27% over three months)

(2) Hedge using a forward contract: is calculated to be $65,320.33 (based on a forward bid exchange rate of 0.4227, discounted at an effective rate of 1.27% over three months)

(3) Hedge using the money market: is calculated to be $64,187.88 (based on a loan payment amount of 146,950.28 BRL on 06/05/06, at a spot bid exchange-rate of 0.4368 (156,502.04 minus 9,551.77 interest at 6.5% for a 3-month loan)

The above data shows that the money markets and forward markets are not in parity. The difference between the discount rates of 6.5% used to arrive at the PV of the money market loan and 5.08% used to arrive at the PV of the anticipated future inflow of BRL from the sale to Novo converted at a forward rate of 0.4227 are the reason why the money markets and forward markets are not in parity

Regardless of how BA chooses to mitigate its exchange-rate risk, the follow-on order is not profitable. Total costs of $66,969 (appendix-3) are higher than the cash inflow from the sale under all three scenarios. Unless BA wants to maintain their relationship with Nova as a source of international sales and will negotiate better deals in the future, they should not make this new sale unless Novo agrees to a price increase per gallon