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I just finished reading KO's annual report. I found the section discussing use of derivatives to hedge against currency risk a bit confusing, since I don't have a handle on how derivatives work. Since most if not all of the Rule Maker companies share currency risk, I was wondering if anyone could explain how these derivatives work and/or point me to some references so I can broaden my knowledge in this area.

Thanks,

MooneyPilot
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I just finished reading KO's annual report. I found the section discussing use of derivatives to hedge
against currency risk a bit confusing, since I don't have a handle on how derivatives work. Since
most if not all of the Rule Maker companies share currency risk, I was wondering if anyone could
explain how these derivatives work and/or point me to some references so I can broaden my
knowledge in this area.


A company like KO reports its finances, and measures its success, in U.S. dollars. Let's say it sells $100 million of its products in Japan and prices them based on today's exchange rate. By the time it gets paid, the Japanese yen may have appreciated or depreciated by 10%. The company's profits may be wiped out when it receives those yen, or it may double. Management doesn't want to be subject to those fluctuations, which are not under its control. They want to avoid that risk. Given that they expect $100 million in Japanese currency to come in the door in three months, they can buy a futures contract where they are guranteed to convert the yen to dollars at today's rate. In effect, a futures contract is an insurance policy against currency risk. Like any insurance, it costs money.

Elan
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I read that that is part of why Boeing got beat up last fall. It accepted orders in the far east based on far eastern currency. Because they did not hedge those currencys, the stronger the dollar gets, the less they get paid for the planes they sell under those contracts.
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"I read that that is part of why Boeing got beat up last fall. It accepted orders in the far east based on far eastern currency.
Because they did not hedge those currencys, the stronger the dollar gets, the less they get paid for the planes they sell under
those contracts. "

My understanding is that Boeing gets paid in US dollars. When the asian currency fell, many asian airlines had to cancel orders because the airplanes that they ordered now cost much more with respect to their own currency. They simply could not afford them any more.

Domer
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Thanks Elan for your reply. This makes a great deal of sense. Do you have any idea what this "insurance" typically costs? I assume it varies depending on recent volatility in exchange rates and relative price movements of the dollar vs other currencies. In other words, what are the approximate incremental costs from currency risk that a company faces when operating internationally? I don't trade in futures at all so I'm just trying to get a ballpark idea such as 1%, 5%, etc.

Elan wrote:
A company like KO reports its finances, and measures its success, in U.S. dollars. Let's say it sells $100 million of its
products in Japan and prices them based on today's exchange rate. By the time it gets paid, the Japanese yen may have
appreciated or depreciated by 10%. The company's profits may be wiped out when it receives those yen, or it may double.
Management doesn't want to be subject to those fluctuations, which are not under its control. They want to avoid that risk.
Given that they expect $100 million in Japanese currency to come in the door in three months, they can buy a futures contract
where they are guranteed to convert the yen to dollars at today's rate. In effect, a futures contract is an insurance policy against
currency risk. Like any insurance, it costs money.
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Thanks Elan for your reply. This makes a great deal of sense. Do you have any idea what this
"insurance" typically costs? I assume it varies depending on recent volatility in exchange rates and
relative price movements of the dollar vs other currencies. In other words, what are the
approximate incremental costs from currency risk that a company faces when operating
internationally? I don't trade in futures at all so I'm just trying to get a ballpark idea such as 1%,
5%, etc.


I don't know off the top of my head, but futures prices are routinely listed. The future exchange rates for major currencies like the British pound, yen, and Euro, for 3, 6, and 12 months out, are listed in the exchange rate section of my daily newspaper.

Elan
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What are the approximate incremental costs from currency risk that a company faces when operating internationally?

It depends on the Government policy / currency / market expectation / volatility / interest rate differentials. SE Asia, within the last year, to hedge would have cost upwards of 50%
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