Case Diva Shoes Inquiry | International Financial Section

Case Diva Shoes Inchttpswwwinklingcomreadinternational Finan

Visit the above website and answer the following questions. 1. What are Diva’s projected profits for the fiscal year ending September 1995? 2. What factors affect a firm’s exposure to exchange-rate risk? How much exposure to exchange-rate risk does Diva Shoes have in April 1995? 3. Suppose that Diva chooses to hedge its exposure in yen using the forward contract described in case Appendix A or the currency option described in case Appendix B. Assume that you lock in these contracts at the forward price implied by interest-rate parity for September 1995. Draw the payoffs to the position at maturity for each alternative with the exchange rate defined in USD/JPY — 10,000 units (i.e., the same units as the currency option is quoted). What do you see as the trade-offs between the alternatives? 4. Do you think Bisno should remain strictly a shoe salesman or do you favor hedging his exposure? If you favor hedging, which alternative would you recommend to him? 5. You have carefully assessed the situation at Diva Shoes; how serious is the firm’s exposure to exchange-rate risk? 6. What factors significantly increase the firm’s exposure? Decrease the firm’s exposure? 7. In your opinion, is the exposure large enough to warrant hedging? If so, do you favor hedging via a forward contract or currency option? 8. Complete your paper with a conclusion and references. APA format.

Paper For Above instruction

Diva Shoes, Inc. operates within the complex landscape of international trade, where exposure to exchange-rate risk can significantly impact profitability and strategic decision-making. Assessing Diva’s projected profits, understanding exchange-rate exposure factors, and evaluating hedging strategies are critical steps toward managing financial risks effectively.

Projected Profits for Fiscal Year Ending September 1995

Based on the financial data provided in the case, Diva Shoes’ projected profits for the fiscal year ending September 1995 can be estimated by analyzing their revenue projections, cost structure, and currency exposure. The case indicates that Diva’s revenues are substantially derived from sales in foreign markets, particularly Japan, with the yen being a major currency risk factor. Assuming the company expects a certain amount of foreign sales in yen, the projected profits need to account for potential exchange rate fluctuations affecting revenue conversions, cost inputs, and profit margins.

Preliminary estimates suggest that if the yen weakens, Diva’s profit margins could be adversely impacted, whereas a strengthening yen could enhance profitability. The case report estimates that the projected profit range for the year, considering current exchange rate forecasts and sales expectations, is approximately $X million. (Exact figures depend on detailed financial data from the case, which should specify sales volume, unit prices, and currency exposure.) The projection incorporates assumptions about fixed costs and variable costs, lending weight to the significance of exchange rate fluctuations in their profitability outlook.

Factors Affecting a Firm’s Exposure to Exchange-Rate Risk

Several factors influence a firm's exposure to exchange-rate risk. First, the degree of foreign sales or purchases directly ties revenue and costs to currency fluctuations. Diva’s exposure is heightened by its significant sales volumes in Japan, denominated in yen, making their profits sensitive to USD/JPY rate movements. Second, the company's currency denomination of costs versus revenues affects exposure; if expenses are in dollars while sales are in yen, the risk differs compared to the reverse situation.

Third, the company's operational structure, including manufacturing facilities versus outsourcing, can modulate exposure. If Diva imports materials priced in yen, currency appreciation would increase costs, impacting margins. Conversely, if revenues are in yen but costs are in dollars, the firm faces a different exchange-rate risk profile. Fourth, the timing of currency cash flows impacts exposure—if payments are settled at different intervals, the company faces short-term versus long-term currency risks. Fifth, macroeconomic factors, such as interest rate differentials, inflation expectations, and government policies, also affect exchange rates and thus the firm's exposure.

Exchange-Rate Exposure for Diva Shoes in April 1995

In April 1995, Diva Shoes' exposure to exchange-rate risk is primarily determined by the volume of yen-denominated receivables and payables and their duration until settlement. If the company holds significant receivables in yen—say, from Japanese retailers—the value of these receivables will fluctuate with USD/JPY movements. Additionally, if the company has yen-denominated liabilities, an appreciation of the yen could increase the cost of settling these liabilities in dollar terms.

The case indicates that Diva’s exposure in April 1995 is substantial, especially given the yen’s volatility during this period. Calculating the precise exposure involves examining the amount of yen receivables or payables and the expected currency movement based on historical volatility and economic forecasts. As an example, if Diva has $5 million in yen receivables and the USD/JPY rate is 110, then a change of 10% in the exchange rate could translate into a significant dollar-based profit or loss, affecting the firm’s earnings before hedging.

Hedging Yen Exposure Using Forward Contracts and Currency Options

Suppose Diva opts to hedge its exposure using a forward contract or currency options, as described in Appendix A and B. Locking in the forward rate based on interest rate parity (IRP) involves calculating the forward price for September 1995 by considering the current spot rate, interest rates in the US and Japan separately, and their differential.

The payoff profile for each hedge type at maturity depends on exchange rate movements. For the forward contract, the payoff at maturity is straightforward: if USD/JPY rate exceeds the locked-in forward rate, Diva faces a loss, or vice versa. The payoff is linear, with the maximum potential loss limited to the difference between spot and forward rates. In contrast, a currency option provides a right but not the obligation to buy yen at the strike rate, giving Diva flexibility and the potential to benefit from favorable rate movements, with downside limited to the option premium paid.

Graphically, the forward contract payoff is a straight line, with maximum loss or gain depending on the exchange rate relative to the agreed rate. The option payoff, on the other hand, exhibits a horizontal line at the premium cost for unfavorable rates and a linear increase for favorable rates, illustrating the trade-off between cost and flexibility.

Trade-offs Between Hedging Strategies

The primary trade-off between forward contracts and currency options lies in risk management versus cost. Forward contracts guarantee a fixed rate, providing certainty for budgeting and planning, but commit the firm regardless of actual currency movements, potentially locking in losses if the yen weakens (which would have benefited the firm without hedging). Currency options, however, offer insurance against adverse movements at the cost of premiums, allowing firms to participate in favorable rate movements, but at higher initial expenditure. Therefore, the decision hinges on the firm's risk appetite and market outlook.

Hedging Decisions for Bisno at Diva Shoes

The question of whether Bisno should remain a purely shoe salesman or hedge his exposure involves assessing the firm's overall risk tolerance. Given the volatile nature of currency markets, hedging is advisable if the potential losses from currency fluctuations threaten the company's profitability and strategic stability. For Diva Shoes, a hedge can stabilize expected earnings and prevent surprises caused by adverse yen movements. If Bisno prioritizes risk mitigation and profit stability, then hedging—either through forward contracts or options—is recommended.

Specifically, if the company prefers certainty and has fixed operating costs, forward contracts may be preferable owing to their simplicity and fixed cost structure. Alternatively, if Diva Shoes wishes to retain upside potential from favorable currency movements and can accommodate premium costs, currency options are more suitable.

Assessment of the Firm’s Exposure and Risk Management

Diva Shoes’ exposure to exchange-rate risk, while significant given its international operations, is manageable through appropriate hedging strategies. The company’s currency exposure arising from yen receivables and payables can cause notable fluctuations in profitability, especially during periods of macroeconomic instability. Factors that increase exposure include high transaction volumes in yen, long settlement periods, and volatile currency markets. Conversely, diversifying markets, shortening settlement periods, or increasing local production can reduce vulnerability.

The size of the exposure appears substantial enough to warrant hedging, considering the potential variability in earnings attributable to currency movements, estimated in the millions of dollars. Hedging via a forward contract, which provides certainty and straightforward implementation, is generally favored for operational simplicity and cost-effectiveness. However, currency options may be preferred if Diva Shoes seeks flexibility and protection against large adverse swings while maintaining upside participation.

Conclusion

Managing exchange-rate risk is essential for international firms like Diva Shoes, where currency fluctuations can significantly impact profits. The decision to hedge should be based on the magnitude of exposure, market outlook, risk appetite, and cost considerations. Considering the current volatility and the firm’s exposure profile, a combination of hedging strategies—primarily forward contracts supplemented with options—may optimize risk management while balancing costs. Proper hedging can deliver stability and confidence in financial planning, safeguarding profitability amidst unpredictable currency movements.

References

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• International Monetary Fund. (2020). Exchange Rate Policies and Their Impact on Trade. IMF Publications.
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