Help DKNY Cover Up its Mexican Peso Exposure Transaction

April 2011

TABLE OF CONTENTS
Answers to Questions page 263 Question 1.p.3 Question 2p.3 Question 3...p.3 Question 4...p.3 Question 5...p.4 Question 6...p.4 Question 7...p.5 Question 8...p.5

Answers to questions in page 263

Question 1 Hedging funds is a term used to depict any investment fund that uses derivative strategies to reduce risk on the transaction. Products can vary from funds that support investment decisions on stock picking, mainly of undervalued and distressed stocks. Also there are funds, which play on macro-economic changes. The hedging options are the following three: Forward market hedge, Money market hedge and Options hedge. Question 2 We are looking for the dollar cost of the payable that DKNY can lock in by using the forward contract. To sell pesos forward at peso 11,03/$. When this transaction occurs 7 million Pesos = 7 million / 11,03 = $ 634.632,82 So DKNY can lock in a dollar cost of $634.632,82. Question 3 DKNY can hedge its payable by borrowing the dollar equivalent of the present value of the 7 million Mex$ payable, which equals: 7 million/ [1+ (0,15*1/12)] = 69.135.802 Mex$. Now, converting the amount is us$ using the spot rate and this equals: 69.135.802/ 10,93 = 632.532,502 Now the cost of borrowing can be calculated as: (632.532,502* 0,075 *1/12) + 632.532,502 = $636.485,83. Question 4 By buying a Mex$ put option, DKNY can lock in a cost of: (0,01*7 millions/10,93) = 6.404,3915 plus 7 millions/ 10,83 = $ 652.757,1139. Here we have calculated the sum of 1% put premium plus the cost of buying pesos through the put option at a rate of Mex$ 10,83/ $.

Question 5 The cost of the option on pesos equals the cost of the forward market hedge when there is fixed exchange rate. In other words, when we have fixed exchange rate, then there is no volatility and as a consequence spot = forward. Here we must keep in mind that for any exchange rate less than Ptas 11,3/$, the forward contract will always be less expensive than the put option by the amount of the put premium, or $ 6.404,3915. For a spot rate in 30 days, S30, greater than Ptas 11,3/$, the put option will not be exercised and so DKNY's cost of hedging is payable via the peseta put option will be just the put premium plus the cost of buying pesetas in the spot market, or $ 6.404,3915 + 70,000,000/S30. At the same time, since the forward contract must always be settled, the cost of hedging the with a forward contract will always be $634.632,82. To find the exchange rate at which the cost of using the put option just equals the cost of using the forward contract, we set these two figures equal: 6.404,3915 + 7.000.000/S30 = $634.632,82 or S30 = 7.000.000/ 628.228,428 = Mex$11,142/$ Question 6 DKNY can create a currency collar by simultaneously buying an out-of-themoney put option and selling an out-of-the-money call option of the same size. In effect, the purchase of the put option is financed by the sale of the call option. So, DKNY can buy a put option on dollars at Mex$ 10,83/$ and sell a call option on dollars at 11,03 Mex$. The net premium paid is actually a receipt of funds in the amount of $12.808,78 which is the difference between the $6.404,3915 (0,01*7.000.000/10,93) paid for the put option and the $19.213,174 (0,03* 7.000.000/10,93 ) received from the sale of the call option. If the spot rate in 30 days is Mex$ 10, 75/$, DKNY will exercise its put option and pay $652.757,1139 (from question 4) to buy Mex$ at a rate of Mex$ 10,83 /$. At the same time, the buyer of the call option will allow its option to sell Mex$ 7.000.000 to DKNY at a price of Mex$ 11,03 to expire unexercised. The net dollar cost of the payable, therefore, is the difference between the $652.757,1139 paid for
4

the Mex$ and the $12.808,78 net option premium received. This is equal to $639.948,33. At a spot rate of Mex$ 11,03/$, DKNY will allow its option to buy Mex$ to expire unexercised but it will be forced by the holder of the call option to buy 7 million Mex$ at a price of 11,03 /$, or $634.632,81 (7.000.000/11,03). DKNY's net dollar cost of hedging its payable, including receipt of the $12.808,78 net option premium, will be $621.824,03. This figure also equals the net cost to DKNY of hedging its payable if the 30-day spot rate is Mex$ 11,25/$ because the same dynamics as before hold i.e. DKNY will not exercise its option but the holder of the call option will exercise its option. Question 7 The preferred alternative would ordinarily be the forward contract because it precisely targets the risk and is less expensive than the money market hedge. However, we have seen from the answer to question 6 that the currency collar will be less expensive than the forward contract.($621.824,03 as opposed to $634.632,82) The put option on its own offers the opportunity to save some money, but DKNY would pay for this opportunity with the 1% premium. Then the question becomes whether the premium more or less offsets the potential benefit of saving money with the call option. This is speculation, which a company should not be in business to engage in. Question 8 If the 30 day spot rate is expected to be Mex$ 11,25 /$, the DKNY still had to hedge this payable because if the transaction remains unhedged, the company inquires the risk. The sole aim of hedging is to eliminate or reduce risk. Therefore regardless of the expectations (which are just expectations and they do not provide any solid guarantees), the company is to use the most appropriate hedging option. The factors that influence DKNY decision are the following: how urgent do we need money and what are the costs of the hedging option as well as the cost of capital.
5