Case: Foreign Exchange Trading at Baldwin Enterprises
Baldwin Enterprises is a large manufacturing company with operations and sales
divisions located in the United States and several other countries. The CFO of the
organization, Wes Hamrick, is concerned about the amount of money Baldwin has
been paying in transaction costs in the foreign exchange markets and has asked
you to help optimize Baldwin’s foreign exchange treasury functions. With
operations in several countries, Baldwin maintains cash assets in several different
currencies: U.S. dollars (USD), the European Union’s euro (EUR), Great Britain’s
pound (GBP), Hong Kong dollars (HKD), and Japanese yen (JPY). To meet the
different cash flow requirements associated with the company’s operations
around the world, Baldwin must often move funds from one location (and
currency) to another. For instance, to pay an unexpected maintenance expense at
their facility in Japan, Baldwin may need to convert some of its holdings in
U.S. dollars to Japanese yen.
The foreign exchange (FX) market is a network of financial institutions and brokers
in which individuals, businesses, banks, and governments buy and sell the
currencies of different countries. They do so in order to finance international trade,
invest or do business abroad, or speculate on currency price changes. The FX
market operates 24 hours a day and represents the largest and most liquid
marketplace in the global economy. On average, the equivalent of about $1.5 trillion
in different currencies is traded daily in the FX market around the world. The
liquidity of the market provides businesses with access to international markets for
goods
and services by providing foreign currency necessary for transactions
worldwide (see
http://www.ny.frb.org/fxc).
The FX market operates in much the same way as a stock or commodity
market where there is a bid price and ask price for each commodity (or, in this case,
currency). Abid price is
the price at with the market is willing to buy a particular currency, and the ask
price is the price at which the market is willing to sell a currency. The ask prices
are typically
slightly
higher than the bid prices for the same currency — representing the
transaction cost or
the profit earned by the organizations that keep the market liquid. The
following table summarizes the current FX rates for the currencies Baldwin currently
holds. The entries in this table represent the conversion rates from the row
currencies to the column currencies.
Convert/to
USD
EUR
GBP
HKD
JPY
USD
1
1.01864 0.6409
7.7985
118.55
EUR
0.9724
1
0.6295
7.6552
116.41
GBP
1.5593
1.5881
1
12.154
184.97
HKD
0.12812
0.1304
0.0821
1
15.1005
JPY
0.00843
0.00856
0.0054
0.0658
1
For example, the table indicates that 1 British pound (GBP) can be
exchanged (or sold) for 1.5593 U.S. dollars (USD). Thus, $1.5593 is the bid price, in
U.S. dollars, for 1 British pound. Alternatively, the table indicates 1 U.S. dollar (USD)
can be exchanged (sold) for 0.6409 British pounds (GBP). So, it takes about 1.5603
U.S. dollars (or 1/0.6409) to buy 1 British pound (or the ask price, in U.S. dollars, for
1 British pound is roughly $1.5603). Notice that if you took 1 British pound,
converted it to 1.5593 U.S. dollars, and then converted those 1.5593 dollars back
to British pounds, you would end up with only 0.999355 British pounds (that is,
1 * 1.5593 * 0.6409 = 0.999355). The money you lose in this exchange is the
transaction cost. Baldwin’s current portfolio of cash holdings includes 2 million
USD, 5 million EUR, 1 million GBP, 3 million HKD, and 30 million JPY. This
portfolio is equivalent to $ 9,058,560 USD under the current exchange rates
(given earlier). Wes has asked you to design a currency- trading plan that would
increase Baldwin’s euro and yen holdings to 8 million EUR and 54 million JPY,
respectively, while maintaining the equivalent of at least $ 250,000 USD in
each currency. Baldwin measures transaction costs as the change in the USD
equivalent value of the portfolio. As Wes’ assistant, he has asked you to figure out
the optimal trading plan?
Task
- Formulate and solve this problem as a Linear Programme in Excel.
- Produce the sensitivity report for the LP.
- Using the above output, analyse the above case and write a report for Wes
advising him the optimal trading plan. The report should include:
•
Formulation of the Linear Programming problem .
•
Screenshots of the Excel spreadsheet model.
•
Statement of the recommended solution.
•
Discussion of the interpretation of the sensitivity report.
2
•
Discussion of assumptions made in applying Linear Programming to Wes’
problem.
•
Extended analysis that would be useful to Wes followed by more general
suggestions, including a statement of requirements to carry out the extended
analysis
