Harvard Case - Carter + Smith: Exchange Rate Risk Hedges
"Carter + Smith: Exchange Rate Risk Hedges" Harvard business case study is written by Maximiliano Gonzalez, Juan Pablo Davila. It deals with the challenges in the field of Finance. The case study is 11 page(s) long and it was first published on : Feb 2, 2021
At Fern Fort University, we recommend that Carter + Smith implement a comprehensive strategy to mitigate exchange rate risk. This strategy should include a combination of forward contracts, options contracts, and currency diversification. The firm should also carefully consider the potential impact of Brexit and other global economic uncertainties on its operations and adjust its hedging strategy accordingly.
2. Background
Carter + Smith is a UK-based company that manufactures and distributes specialty chemicals. The company has a significant portion of its sales and operations in the Eurozone, exposing it to exchange rate fluctuations between the British Pound (GBP) and the Euro (EUR). The case study highlights the company's concern about the potential impact of Brexit on its business, particularly the uncertainty surrounding the future exchange rate between the GBP and the EUR.
The main protagonists of the case study are:
- David Carter: CEO of Carter + Smith, concerned about the potential impact of Brexit on the company's profitability.
- Sarah Smith: CFO of Carter + Smith, responsible for managing the company's financial risks, including exchange rate risk.
3. Analysis of the Case Study
This case study can be analyzed through the lens of financial risk management, specifically focusing on exchange rate risk. The company faces several challenges:
- Exposure to Currency Fluctuations: Carter + Smith's significant Eurozone operations make it vulnerable to fluctuations in the GBP/EUR exchange rate.
- Brexit Uncertainty: The outcome of Brexit and its impact on the GBP/EUR exchange rate is uncertain, creating a significant risk for the company.
- Limited Hedging Experience: Carter + Smith has limited experience with hedging strategies, making it difficult to determine the most appropriate approach.
To address these challenges, we can apply the following frameworks:
- Financial Analysis: Analyze the company's financial statements, particularly the income statement and balance sheet, to assess the impact of exchange rate fluctuations on profitability and cash flow.
- Risk Assessment: Identify and quantify the potential risks associated with exchange rate fluctuations, considering both the likelihood and impact of different scenarios.
- Hedging Strategies: Evaluate different hedging options, including forward contracts, options contracts, and currency diversification, to determine the most effective approach for Carter + Smith.
- Capital Budgeting: Consider the potential impact of exchange rate fluctuations on future investment decisions, particularly those involving foreign investments.
4. Recommendations
To mitigate exchange rate risk, Carter + Smith should implement the following recommendations:
- Develop a Comprehensive Hedging Strategy: This strategy should include a combination of forward contracts and options contracts to lock in favorable exchange rates for a portion of the company's Eurozone sales.
- Diversify Currency Exposure: Carter + Smith should explore opportunities to diversify its currency exposure by increasing sales in other countries with stable currencies.
- Monitor and Adjust Hedging Strategy: The company should continuously monitor the exchange rate environment and adjust its hedging strategy as needed to reflect changing market conditions and economic forecasts.
- Develop a Contingency Plan for Brexit: Carter + Smith should develop a contingency plan to address the potential impact of Brexit on its business, including scenarios for different Brexit outcomes and potential adjustments to its operations and hedging strategy.
- Invest in Financial Expertise: Carter + Smith should invest in financial expertise to enhance its understanding of exchange rate risk and hedging strategies. This could involve hiring a dedicated risk manager or consulting with an experienced financial advisor.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with Carter + Smith's core competency in manufacturing and distribution, while mitigating the risk of exchange rate fluctuations and ensuring the company's long-term profitability.
- External Customers and Internal Clients: The recommendations aim to protect the company's profitability and ensure its ability to meet the needs of its customers and suppliers, both in the UK and the Eurozone.
- Competitors: By mitigating exchange rate risk, Carter + Smith can maintain its competitive advantage in the global market, particularly in light of Brexit's potential impact on other UK-based companies.
- Attractiveness - Quantitative Measures: The recommendations are based on the potential for significant cost savings through hedging and the potential to improve the company's profitability and shareholder value.
6. Conclusion
By implementing a comprehensive strategy to mitigate exchange rate risk, Carter + Smith can significantly reduce its exposure to currency fluctuations and improve its financial stability. This strategy should include a combination of forward contracts, options contracts, and currency diversification, along with a proactive approach to monitoring the exchange rate environment and adjusting hedging strategies as needed.
7. Discussion
Other alternatives not selected include:
- Doing nothing: This option would expose Carter + Smith to significant exchange rate risk, potentially impacting its profitability and financial stability.
- Using only forward contracts: While forward contracts can provide some protection against exchange rate fluctuations, they lack flexibility and may not be appropriate for all situations.
- Using only options contracts: Options contracts provide greater flexibility but can be more expensive than forward contracts.
Key assumptions of the recommendations include:
- The GBP/EUR exchange rate will continue to fluctuate in the future.
- The company's sales and operations in the Eurozone will continue to be significant.
- The company will be able to effectively implement and manage its hedging strategy.
8. Next Steps
To implement the recommendations, Carter + Smith should take the following steps:
- Develop a detailed hedging strategy.
- Identify and secure appropriate hedging instruments.
- Implement a system for monitoring and adjusting the hedging strategy.
- Develop a contingency plan for Brexit.
- Invest in financial expertise to manage exchange rate risk.
By taking these steps, Carter + Smith can effectively mitigate exchange rate risk and position itself for long-term success in the global market.
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Case Description
This case presents a situation where the company Carter + Smith (C+S), which receives U.S. dollars to finance a Colombian pesos project, decided to create a hedge to cover the risk of an ex- change rate fall (revaluation of the COP against the USD). However, shortly after, there was a sharp rise in the exchange rate (devaluation of the peso), and this generated significant losses in the Non Delivery Forwards (NDF) contracts.
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