Hedging At Swiss Watch Co.
An early morning in January 2015, Otto Schwartz, the young Chief Financial Officer (CFO) of Swiss Watch Co. was trying to assemble his thoughts before leaving for office in downtown Zürich. He drank slowly his coffee, and decided that he would spend the whole day writing his report to the Board of Directors of the firm. He wanted to offer them a comprehensive view of the financial challenges that were facing his company.
Swiss Watch Co, a medium-sized company which had its headquarters just outside the economic capital of Switzerland, was engaged in the design, production and selling of mid-priced watches (its products sold for a retail price ranging from 200 to 400 euros). The traditional markets for its products were in Europe and in the USA (65% and 30% of the sales came from these two regions).
The company was active in the design and in the final assembly of its watches, it bought both the metal case and the movement parts from well-known and high quality Swiss suppliers. The past few years have been difficult for SWC, as it faced strong competitive pressure from Japanese and French rivals who took away market share thanks to their more aggressive pricing policy. SWC has adapted its approach to the market and hoped that its new, more customer oriented attitude and lower prices would be successful in bringing back its lost clients.
The company has just completed the reorganization of its sales method: from now on, it would have agreements with a few major trading companies in its main export markets and sell them a large quantity of watches at a slightly discounted price. These trading companies would then sell the watches to local shops, retaining in the process a small commission. The company had just received a new large order that would keep the assembly line busy for the next few months.
A major Chicago-based trading firm has placed a contract worth of 15 million US dollars. The shipment was scheduled to take place in 3 month’s time, and generous payment terms meant that this American customer would have 8 weeks to pay the invoice after receiving the watches. Otto knew that during this time period, his company would have to spend money on acquiring the parts (case and movement parts) needed for the watches, and would of course need to pay out the salaries of his employees.
What caused concern to Otto and his colleagues was the fact that the last deal with an American customer has barely managed to break even. In effect, unanticipated movements occurred in the value of the Swiss Franc as measured against the US Dollar (see chart), which caused a substantial reduction in the expected profit of the given contract.
Otto was now under strong pressure from his colleagues who expected him to avoid a similar fiasco with this new deal. He was therefore putting together a proposal for the Board of Directors in which he would show all possibilities that existed that could be used to prevent such a situation. At the same time, he was also thinking about another deal as well. This second contract, worth 13 millions euros, was due to completion in two month’s time and came from a new German client.
Having studied the past price movements, Otto saw that the Swiss franc has almost not changed in value against the euro in the past 2.5 years and therefore he wondered if he needed to be concerned about this contract at all. Otto also received information from a friend of his regarding the cost of a currency option.
His friend basically told him that while each option’s premium would fluctuate based on the volatility of the underlying currency pair, as a rule of thumb it was true that for the Swiss franc, an at-the-money option would cost him 4 or 5 centimes for every franc, in other words a cost of 4 to 5 percent.
At the same time, he felt that there was the need to make some longer term recommendations as well. As a former finance student, Otto remembered vaguely that several tools and possibilities were available to solve such situations. He was particularly eager to compare the forwards and the options and contrast their cost and their benefit with his company’s needs and possibilities. He would now have the rest of the night to think about them and write up his report…
Questions for the International Finance home assignment:
- Provide a theory-based explanations of the various causes that could have led to the change in the value of the two currencies
- Contrast the various hedging opportunities at Otto’s disposal and discuss their advantages and disadvantages for Swiss Watch Co.
- Provide well-grounded short-term and long-term recommendations to the firm
- With hindsight, provide a critical analysis of the way that the Swiss authorities handled the Swiss franc relative to the euro in the past 10 years
Your answer should respect an academic format and come complete with at least 5 good quality sources referenced. A literature review should be prepared to introduce the main points and concepts discussed later. At the same time it is expected that your answers make sense from a practical point of view and are consistent with the data presented to you. You are encouraged to provide a well laid-out, professionally presented paper, which comes complete with graphs, tables, calculations, etc.
Selected financial indicators of SWC
- Number of watches sold in 2014: 189 687
- Average price in CHF: 320
- EBIDTA in ’000 CHF: 8,497
- Cash in the bank in ’000 CHF: 1 317
