Advanced Derivative Securities and Financial Risk

Management— FN 442

Transcript of Foreign Exchange Hedging Strategies at Apple Inc.

FOREIGN EXCHANGE HEDGING STRATEGIES AT APPLE INC: TRANSACTIONAL AND
TRANSLATIONAL EXPOSURES

Background
Apple Inc. is an American multinational technology company headquartered in Cupertino,
California that designs, develops, and sells consumer electronics, computer software, and
online services.
Founded: April 1, 1976, Cupertino, CA
Headquarters: Cupertino, CA
Founders: Steve Jobs, Steve Wozniak, Ronald Wayne
Products: iPhone, iPad, Macintosh, iPod, Apple Watch, iPhones X, MORE
Subsidiaries: Beats Electronics, Apple Store, MORE

Apple Inc. Treasurer’s Office

One of the key functions of the treasurer’s office is financial risk management, which includes
management of not only market risk (Foreign Exchange, interest rate and commodities
exposures) but also counterparty, corporate and operational risk.
For Foreign Exchange (FX), all of Apple‘s hedging activities are concentrated in two centers:
• The Domestic Finance Group in Cupertino handles FX hedging for Apple entities located in
North America, Latin America, Africa and Middle East.
• The European Regional Treasury Centre (ERTC) is Apple’s largest foreign exchange operation,
covering European and Asia Pacific FX Exposures

Review of Corporate Hedging Policy

General corporation hedging policy
1. Reduce cash flow and earnings volatility
2. Minimize the management time and cost dedicated to global FX management
3. Align FX Management in a manner consistent with how Apple would operates its
business
 Forward contract simulation

 Japan presents Apple Treasury with a set of critical decision arising from an increasing
macroeconomic uncertainty.
 Luca Maestri consider how a potential devaluation of the Yen against the dollar from
105 to 155 would impact Apple’s FX exposure over the medium term.
 Maestri and Tim Cook need to decide how to proceed, is it worth the cost to increase
the size of Apple’s hedge position beyond what is typically required by usual policy.
 Reviewed the market for forwards and options on the JPY and compiled historical prices
on 1, 6, and 12-month forward rates of Yen vs dollar.
 The company faces significant level of currency risk due to its geographical
representation in Asia/ Japan.
 The translational risks can be minimized by borrowing in local currency, such that costs
and revenues can be netted in Yen. However there is still translation risk on operating
profits in Yen/ USD
 Examine the Balance sheet and cash flow exposure
Apple Inc., which recently developed the I-Phone 10 and I-Phone 8 imports various parts
from suppliers in Japan and China. One of the largest imported part is the iPhone x’s OLED
screen. The iPhone X is the first iPhone to feature an OLED screen, while the iPhone 8 and the 8
Plus, have an LCD screen like Apple's previous phones. The OLED technology is new for Apple,
however anyone who uses Samsung phones (or the Google Pixel, or the new Essential Phone) is
already familiar with OLED. In fact, Samsung has been using OLED screens since its first Galaxy
phone came out seven years ago.

OLED, short for organic light-emitting diode, is a type of display technology. It differs from the
more widely used LCD (liquid crystal display) tech by creating light within every pixel that makes
up its picture, instead of requiring a separate backlighting system. This means it can produce
perfectly dark blacks. Rather than trying to cover up a backlight behind the scenes and
inevitably letting some light through, it shuts off the appropriate pixels. The result is an infinite
contrast ratio — i.e., the difference between a display's darkest blacks and brightest whites,
which in turn, means an OLED panel, can produce a more vivid, realistic picture.

Worried that Apple may be ill prepared for potential shocks in the FX market, Tim Cook looks to
a friend at WEX for guidance on how to hedge the firm’s Yen exposure. WEX recommend that
Cook works with one of its recent hire Minauti on a contractual basis to assist with deriving a
strategy to protect against the Yen’s potential volatility in the Yen against the Dollar. Apple
subsequently retained Minauti. Her mandate is to review and recommend strategies that are
consistent with Apple’s hedging policy to protect its FX exposure.

Use of Currency Derivative Instruments

Apple, Inc. needs to order supplies 2 months ahead of the delivery date. It is considering
an order from a Japanese supplier that requires a payment of 25 million yen payable as of
the delivery date.

Apple has two choices:

 Purchase four call options contracts (since each option contract represents
6,250,000 yen).
 Purchase one futures contract (which represents 25 million yen).

The futures price on yen has historically exhibited a slight discount from the existing
spot rate. However, the firm would like to use currency options to hedge payables in
Japanese yen for transactions 2 months in advance. Apple prefers hedging its yen
payables because it is uncomfortable leaving the position open given the historical
volatility of the yen. Nevertheless, the firm would be willing to remain unhedged if
the yen becomes more stable someday.

Luca Maestri and Apple's Chief Financial Officer (Bridget Lyons CFO), prefer the
flexibility that options offer over forward contracts or futures contracts because
she can let the options expire if the yen appreciates. The CFO would like to use an
exercise price that is about 6.5 percent from the existing spot rate (note the 3
month forward is 33 points from spot) to ensure that Apple will have to pay no more
than 3 percent above the existing spot rate for a transaction 2 months beyond its
order date, as long as the option premium is no more than 1.2% percent of the price
it would have to pay per unit when exercising the option.
In general, Yen options have a premium of about 1.5 percent of the total transaction
amount that would be paid if the option is exercised. For example, recently the yen
spot rate was 109.74, and the firm purchased a call option with an exercise price of
113.5, which is 3 percent from the prevailing the spot rate. The premium for this
option is 25.5, which is 1.5 percent of the price to be paid per yen if the option is
exercised.

A recent event caused more uncertainty about the yen's future value; although it did
not affect the spot rate or the forward or futures rate of the yen. Specifically, the yen's
spot rate was still 109.76, but the option premium for a call option with an exercise
price of 113.5 is now 28.7. How can this be ?
An alternative call option is available with an expiration date of 2 months from now;
it has a premium of (which is the size of the premium that would have existed for the
option desired before the event), but it is for a call option with an exercise price of
113.50. The table (CME) below summarizes the option and futures information
available to Apple: As a consulting Analyst for Apple, Minauti has been asked to offer
insight on how to hedge. Use a spreadsheet to support your analysis.
If Apple uses call options to hedge its yen payables, should it use the call option with
the exercise price of or the 112.5 call option with the exercise price of 113.5?
Describe the tradeoff.
Also you should consider if Apple should hedge from 1 to 3 months

Hedging of Medium Term Operating Revenues

In addition to hedging short term accounts payables, Lyons and Cook are also concerned
about the impact of a sustained depreciation of the yen (and other correlated regional
currencies) on the reported earnings of Apple.
Accordingly, they have asked Masteri to consider a plan to hedge 50 % of the regions net
operating revenue.
Using the segmented accounts from Apples most recent 10 k filing with the SEC, using the
past 3 years data, consider a hedging proposal using either forward or USD/ JPY cross
currency swaps. In your analysis consider the forward points versus the implied volatility (and
not just interest rate differentials) in your break even analysis.
In addition Aplle could look at using cross currency swaps in its hedging profile.

Historical spots rates can be found below.

https://www.bloomberg.com/quote/USDJPY:CUR

The forward rates can be found below.

https://www.barchart.com/forex/quotes/%5EUSDJPY/forward-rates

A primer on Currency swaps (make sure you read this!)

https://www.citibank.co.kr/cgrp_pjt/jsp/en/fed/fed040040v.jsp?gnbname=fed

Current USD-JPY options

https://www.investing.com/currencies/usd-jpy-options

http://www.cmegroup.com/trading/fx/g10/japanese-yen.html
The segmented accounts for Apple are available in EDGAR
https://www.sec.gov/Archives/edgar/data/320193/000032019317000070/a10-
k20179302017.htm#s63EA20E94A5151458E162BF17BAE3A6F