Free Hedging IDR Exposure through Onshore Forward or NDF? Case Study Solution | Assignment Help

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Written by Gary F. Smith
Publish Date: 2024-11-03

Harvard Case - Hedging IDR Exposure through Onshore Forward or NDF?

"Hedging IDR Exposure through Onshore Forward or NDF?" Harvard business case study is written by Yoon Kee Kong. It deals with the challenges in the field of Finance. The case study is 10 page(s) long and it was first published on : Nov 18, 2018

At Fern Fort University, we recommend that PT. Prima Karya Utama (PKU) hedge its IDR exposure through onshore forward contracts. This strategy offers a superior balance of risk management, cost-effectiveness, and regulatory compliance compared to Non-Deliverable Forwards (NDFs).

2. Background

PT. Prima Karya Utama (PKU), a leading Indonesian manufacturer of consumer goods, faces significant exposure to Indonesian Rupiah (IDR) fluctuations due to its substantial USD-denominated debt. The company is considering two hedging strategies: onshore forward contracts and NDFs. The case study explores the trade-offs between these options, considering factors like cost, liquidity, regulatory environment, and potential risks.

The main protagonists are:

  • Mr. Budiman: PKU's Finance Director, responsible for managing the company's financial risks.
  • Ms. Sari: PKU's Treasury Manager, tasked with implementing the chosen hedging strategy.

3. Analysis of the Case Study

This case study can be analyzed using a financial risk management framework:

  • Identification: PKU faces currency risk due to its USD-denominated debt and IDR-denominated revenues.
  • Measurement: PKU needs to quantify the potential impact of IDR fluctuations on its financial performance. This can be done through sensitivity analysis and scenario planning.
  • Management: PKU can choose from various hedging instruments, including onshore forward contracts, NDFs, and options.
  • Monitoring: PKU must continuously monitor the effectiveness of its hedging strategy and make adjustments as needed.

Key Considerations:

  • Onshore Forward Contracts:
    • Advantages:
      • Transparency: Traded on regulated exchanges, providing greater transparency and regulatory oversight.
      • Liquidity: Higher liquidity in the Indonesian market, offering better execution and pricing.
      • Legal Certainty: Enforceable under Indonesian law, reducing legal risks.
    • Disadvantages:
      • Cost: May be more expensive than NDFs due to higher transaction costs and regulatory fees.
  • Non-Deliverable Forwards (NDFs):
    • Advantages:
      • Lower Cost: Typically cheaper than onshore forward contracts.
      • Flexibility: Can be tailored to specific needs and risk profiles.
    • Disadvantages:
      • Counterparty Risk: NDFs are not traded on regulated exchanges, increasing counterparty risk.
      • Regulatory Uncertainty: NDFs are not fully regulated in Indonesia, raising concerns about legal enforceability.
      • Limited Liquidity: Lower liquidity compared to onshore forward contracts, potentially leading to difficulty in execution and price discovery.

4. Recommendations

We recommend that PKU hedge its IDR exposure through onshore forward contracts. Here's the implementation plan:

  1. Assess IDR Exposure: Conduct a comprehensive analysis of PKU's IDR exposure, considering the size of its USD-denominated debt, the expected duration of the exposure, and potential future financing needs.
  2. Determine Hedging Strategy: Based on the exposure assessment, determine the optimal hedging ratio, considering the desired level of risk mitigation.
  3. Select Financial Institution: Choose a reputable financial institution with a strong track record in foreign exchange transactions and a deep understanding of the Indonesian market.
  4. Negotiate Forward Contract Terms: Negotiate the contract terms, including the forward price, maturity date, and any other relevant clauses.
  5. Monitor and Adjust: Continuously monitor the effectiveness of the hedging strategy and make adjustments as needed based on market conditions and PKU's evolving risk profile.

5. Basis of Recommendations

This recommendation considers the following factors:

  1. Core Competencies and Mission: PKU's core competency lies in manufacturing and operations. By hedging its IDR exposure, PKU can focus on its core business, reducing financial risks and enhancing profitability.
  2. External Customers and Internal Clients: Hedging protects PKU from currency fluctuations, ensuring stable pricing for its products and predictable cash flows for its operations.
  3. Competitors: By managing its currency risk effectively, PKU can maintain a competitive advantage in the Indonesian market.
  4. Attractiveness: Onshore forward contracts offer a higher degree of transparency, liquidity, and regulatory compliance, making them a more attractive option than NDFs.

6. Conclusion

PKU should prioritize hedging its IDR exposure through onshore forward contracts. This strategy provides a balanced approach to risk management, cost-effectiveness, and regulatory compliance. By adopting this recommendation, PKU can mitigate its currency risk, enhance financial stability, and focus on its core business operations.

7. Discussion

While NDFs offer a cheaper alternative, the potential risks associated with counterparty risk, regulatory uncertainty, and limited liquidity outweigh the cost savings.

Key Assumptions:

  • The Indonesian Rupiah will continue to be volatile in the foreseeable future.
  • PKU's business operations will remain stable, allowing for a predictable cash flow stream.
  • The Indonesian financial market will continue to develop and mature, providing greater access to onshore forward contracts.

8. Next Steps

  1. Within 1 month: Conduct a comprehensive assessment of PKU's IDR exposure and determine the optimal hedging ratio.
  2. Within 2 months: Select a reputable financial institution and negotiate the terms of the onshore forward contracts.
  3. Within 3 months: Implement the hedging strategy and begin monitoring its effectiveness.

By taking these steps, PKU can effectively manage its IDR exposure and achieve its financial goals.

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Case Description

Michael Finney, CEO of US-domiciled Deltrix Lumberjack, pitched his company's logging equipment to an Indonesian logging firm. Indonesian regulation required all quotations to be denominated in Indonesian Rupiah (IDR). Amidst intense competition, Michael improved his quotation from IDR equivalent to US$4.85 million, to that equivalent to US$4.70 million. This would result in a razor-thin margin for the company as a mere 10% depreciation of the IDR could wipe out Deltrix's US$ profits for this transaction. Michael tasked his treasurer, Dan Martin, to study the recent trend of the US$-IDR exchange rate and to recommend whether Deltrix should hedge the IDR receivables, due six months later, if Deltrix's tender was successful. And if Dan's recommendation was to hedge, whether hedging using the onshore or offshore IDR forward market would be more effective. Offshore hedging would be executed via the IDR Non-Deliverable Forward (NDF) market. A NDF, unlike the traditional forward transaction, would not involve exchange of principals in the two currencies. NDFs were settled via the payment of a Settlement Amount (similar to profit of forwards), which together with the spot transaction to be effected at maturity, would result in a (non-perfect) hedge of the amount of US$ to be converted.

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