Case lets Axis Hedges the Euro In 1999 when the European Union introduced the euro, Michael Jones, owner, and CEO of Axi
Posted: Wed Apr 27, 2022 10:42 am
Case lets
Axis Hedges the Euro
In 1999 when the European Union introduced the euro, Michael
Jones, owner, and CEO of Axis Ltd., a small manufacturer of wiring
components for the aerospace industry, though it would be a good
idea to start pricing sales to European customers in euros (m). In
late 1998, Axis entered into multi-year deals with two European
aerospace companies to supply wiring. The prices were calculated
using an exchange rate of $1_m1.18, which was just a little
stronger than the exchange rate for the euro at the time of its
introduction in January 1999.
As Jones later noted: “Stupid us! At the time the euro was
introduced, no one thought its value would immediately plunge
against the dollar. We thought the currency would trade in a narrow
range against the dollar, and that pricing in euros was in the best
interests of our European customers.” However, the euro promptly
fell against the dollar, bottoming out at nearly $1_m0.82 in
October 2000.
For Axis, the plunge was devastating. One of the contracts
called for Axis to supply m5 million of wiring to a European
customer in 2000. Axis had hoped to generate $5.9 million in
revenue at an exchange rate of $1_m1.18 (m5 million _ 1.18 _ $5.9
million). The company knew that as long as the euro stayed over
$1_m1.05 it would be able to make a decent profit on the deal.
However, when payment was due, the exchange rate stood at $1_m0.88,
and the m5 million deal netted Axis only $4.4 million in revenues.
Axis lost money that year due to the adverse movement in foreign
exchange rates. The company’s 10 top managers all took 20 percent
pay cuts, there were no profit-sharing bonuses, and no other
employees got a raise. To make sure that didn’t happen again, Jones
began to actively hedge against adverse currency movements in 2000.
To do this, Axis entered the foreign exchange market, buying
currency forward (that is, entering a contract today to buy
currency at some point in the future at a predetermined exchange
rate).
For example, in late 2000, Axis entered a contract to supply
wire to a European customer in the first half of 2001, with payment
due in June 2001. The total value of the contract was m2.5 million.
At the time, the prevailing dollar/euro exchange rate was $1_m0.90,
so the contract would generate $2.25 million in revenues for Axis
(m2.5 million _ 0.9_ $2.25 million). To protect this projected
revenue stream from adverse movement in the exchange rate, Axis
entered into a forward contract with the foreign exchange desk of
its bank to change euros into dollars on July 1, 2001. The bank
quoted Axis a rate of $1_m0.94 for making the exchange on that
date, which would guarantee Axis $2.35 million. The higher forward
rate offered by the bank reflected the view of the foreign exchange
market that the euro would appreciate a little against the dollar
over the next year. To Jones, this seemed like a good deal and he
entered the contract. But on July 1, the exchange rate stood at
$1_m0.85. The foreign exchange market was wrong, and the euro had
depreciated against the dollar. Had Axis not entered into the
forward exchange contract, its m2.5 million in revenues would have
been worth only $2.125 million, not the $2.35 million Axis actually
received by executing the forward contract. “It doesn’t always work
in our favor though,” notes Jones. “In 2002, we entered another
forward contract to supply wiring through till early 2003. We
hedged the exchange rate risk by buying dollars forward on the
market at $1_m0.95, which was the forward rate at the time. But
guess what! In March 2003, when the customer had to pay, the
exchange rate stood at $1_m1.07. Had we not hedged, we would have
made a tidy sum on the appreciation in the value of the euro
against the dollar, but I cannot stomach the risk associated with
that type of speculation anymore. I would rather know what I am
getting.
Axis Hedges the Euro
In 1999 when the European Union introduced the euro, Michael
Jones, owner, and CEO of Axis Ltd., a small manufacturer of wiring
components for the aerospace industry, though it would be a good
idea to start pricing sales to European customers in euros (m). In
late 1998, Axis entered into multi-year deals with two European
aerospace companies to supply wiring. The prices were calculated
using an exchange rate of $1_m1.18, which was just a little
stronger than the exchange rate for the euro at the time of its
introduction in January 1999.
As Jones later noted: “Stupid us! At the time the euro was
introduced, no one thought its value would immediately plunge
against the dollar. We thought the currency would trade in a narrow
range against the dollar, and that pricing in euros was in the best
interests of our European customers.” However, the euro promptly
fell against the dollar, bottoming out at nearly $1_m0.82 in
October 2000.
For Axis, the plunge was devastating. One of the contracts
called for Axis to supply m5 million of wiring to a European
customer in 2000. Axis had hoped to generate $5.9 million in
revenue at an exchange rate of $1_m1.18 (m5 million _ 1.18 _ $5.9
million). The company knew that as long as the euro stayed over
$1_m1.05 it would be able to make a decent profit on the deal.
However, when payment was due, the exchange rate stood at $1_m0.88,
and the m5 million deal netted Axis only $4.4 million in revenues.
Axis lost money that year due to the adverse movement in foreign
exchange rates. The company’s 10 top managers all took 20 percent
pay cuts, there were no profit-sharing bonuses, and no other
employees got a raise. To make sure that didn’t happen again, Jones
began to actively hedge against adverse currency movements in 2000.
To do this, Axis entered the foreign exchange market, buying
currency forward (that is, entering a contract today to buy
currency at some point in the future at a predetermined exchange
rate).
For example, in late 2000, Axis entered a contract to supply
wire to a European customer in the first half of 2001, with payment
due in June 2001. The total value of the contract was m2.5 million.
At the time, the prevailing dollar/euro exchange rate was $1_m0.90,
so the contract would generate $2.25 million in revenues for Axis
(m2.5 million _ 0.9_ $2.25 million). To protect this projected
revenue stream from adverse movement in the exchange rate, Axis
entered into a forward contract with the foreign exchange desk of
its bank to change euros into dollars on July 1, 2001. The bank
quoted Axis a rate of $1_m0.94 for making the exchange on that
date, which would guarantee Axis $2.35 million. The higher forward
rate offered by the bank reflected the view of the foreign exchange
market that the euro would appreciate a little against the dollar
over the next year. To Jones, this seemed like a good deal and he
entered the contract. But on July 1, the exchange rate stood at
$1_m0.85. The foreign exchange market was wrong, and the euro had
depreciated against the dollar. Had Axis not entered into the
forward exchange contract, its m2.5 million in revenues would have
been worth only $2.125 million, not the $2.35 million Axis actually
received by executing the forward contract. “It doesn’t always work
in our favor though,” notes Jones. “In 2002, we entered another
forward contract to supply wiring through till early 2003. We
hedged the exchange rate risk by buying dollars forward on the
market at $1_m0.95, which was the forward rate at the time. But
guess what! In March 2003, when the customer had to pay, the
exchange rate stood at $1_m1.07. Had we not hedged, we would have
made a tidy sum on the appreciation in the value of the euro
against the dollar, but I cannot stomach the risk associated with
that type of speculation anymore. I would rather know what I am
getting.