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Essay on Case 37 Note

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Case #37
Baker Adhesives Synopsis and Objectives

Baker Adhesives (Baker) has just made its first foray into international sales and must come to grips with the impact of exchange-rate changes on the profitability of a past order. The company must also formulate a strategy for dealing with exchange-rate risks for future orders. The case is intended as an introduction to exchange-rate risk and the management of that risk. Upon receipt of payment from a past order, the firm realizes that exchange-rate movements have reduced the value of the sale. A follow-on order provides the context for exploring possible mechanisms for managing that risk. In particular, sufficient direction and information is provided to examine both a forward
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Typical possibilities include:

* asking Novo to pay in dollars; * increasing the price to cover the risk; * choosing forward hedges or money-market hedges; * using other currency contracts such as options.

The first is the most obvious, but not as easy as one might think. This is a matter for negotiation, especially in contexts without standardized contracts, but Baker is not in a particularly good bargaining position. It is a small company; it needs the work.

The second point is usually suggested in a number of ways. We should understand there is a risk-and-return trade-off and therefore conclude one can price the risk into the contract.

The forward and money-market hedges are discussed in detail below. At this point, it is sufficient to acknowledge that these financial contracts do mitigate the risk. Other suggested contracts are beyond the scope of this case, but should be acknowledged.

Hedging

Before exploring the two hedges, it is useful to ask what the present value of the expected cash flow would be if Baker remains unhedged. One may question the need to calculate a present value. The cash flow obtained from a money-market hedge and that cash flow will be a current cash flow. Thus, one will either have to calculate present values or future values to make comparisons—and the present value is more naturally interpreted.
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