FOREIGN CURRENCY HEDGING: A SIMULATION Developments in Business Simulation and Experiential Learning, Volume 31, 2004 FOREIGN CURRENCY HEDGING: A SIMULATION Dallas Brozik Marshall University brozik@marshall.edu Alina Zapalska Marshall University zapalska@marshall.edu ABSTRACT This paper presents a foreign currency hedging simulation that spans several periods yet can be completed in a single class session. The simulation can be used to introduce and reinforce the concepts of hedging and can give students experience in constructing various types of hedges. INTRODUCTION Games and simulations can be used to demonstrate principles and provide experiential learning. This type of active learning provides both students and instructors with a break from the traditional classroom routine and can be used to highlight and support lecture-related materials. Interactive learning activities can be designed to be very short, taking less than a single class period, or long enough to span several class periods. Single-period activities have several advantages. A single- period game or simulation can be rich enough to provide a multi- level learning experience. Several different interactions and principles can be demonstrated with a properly constructed single-period simulation. The richness of the experience can then serve as a springboard for several future classroom discussions or lectures. A single-period activity is also flexible. An instructor can move such an activity fairly easily if it is appropriate to reschedule it; multi-period activities can make the instructor a prisoner of the calendar. The subject of the game or simulation can often dictate the length of the activity. Simple concepts, like a demonstration of the free rider problem in economics, may require multiple repetitions of short activities. Simulation of the complexities of bank management can span an entire term. Creating single- period games and simulations that span multiple periods requires that the designer isolate the fundamental concept to be demonstrated and develop a scenario that will play smoothly. LITERATURE REVIEW During the last decade, pedagogy at the university level has experienced a virtual revolution. Previously, the prevailing teaching methodology was that of lecture and discussion, but today it is not unusual to find individual analysis of group roles, group dynamics, individual and group decision making, role- playing, and other human relations skill-building exercises used in the college classroom. These are generally referred to as "experimental" techniques and reflect the attempt of the business disciplines to bring realistic experiences into the university classroom. An important objective in teaching finance is to ensure that students are exposed not only to theoretical frameworks but also to real world situations where they can gain experience in applying their knowledge. A teaching approach that helps meet this objective in the classroom is the use of games and simulations that replicate many aspects of the real financial world. The literature in the area of educational techniques indicates a steadily increasing degree of interest in the use of active learning with simulations and experiential learning (Bouton and Garth 1993, and Cooper and Mueck 1990). In particular, a review of the literature relating to the analysis of the effectiveness of business simulations and experiential learning reveals a number of studies which support the usefulness of the games and simulations (Becker 1995, Johnson and Johnson 1989, Sharan et al. 1984, and Zapalska and Brozik 1998) Numerous games and simulations have been developed to enhance students learning in business, economics, and finance education. The games provide an environment in which students have the opportunity to experiment with new concepts by placing them in market situations. While there are a number of games that include foreign exchange factors (for example, Alston and Chi 1990, Monahan and Goode 1997, and Tansuhaj and Gentry 1988), only a few specifically mention currency hedging (Hamm et al 1990 and Thorelli 1997). Simulations dealing specifically with foreign currency hedging are not readily available. THE SIMULATION The Foreign Currency Hedging Simulation was designed to provide students with the opportunity to make hedging decisions in the context of a dynamic market. Students are given the chance to create several different types of hedges, and the success of these hedges is determined for each period by a roll of the dice. The randomness introduced by the dice simulates real- world market conditions and eliminates the possibility of any player being able to predict the direction of the simulation. This means that even the best laid plans may go awry, and players may choose to rethink their strategies in the process of the simulation. By keeping the focus tight and providing all necessary information, it is possible to simulate several different decision periods in a single class session. This allows the 310 Developments in Business Simulation and Experiential Learning, Volume 31, 2004 students to experience the results of their decisions immediately, to change their strategies in response to market conditions, and to see the effects of those changes. Attachment 1 is the simulation description which is handed out to each group of students at the beginning of the class (the fourth page is a form to help students organize their decision data; it will be necessary to provide one copy of this form for each iteration of the simulation). Since the description is fairly short, it is only necessary to take a few minutes to familiarize the students with the nature of the data presented. Attachment 2 summarizes the results of the possible dice rolls which identifies the exchange rate for each simulation period (three dice must be provided by the instructor, one marked in red). The exchange rates indicated for the various pip counts matches the probability distribution in Attachment 1. (The instructor may choose to bias the information by consistently adding or subtracting one or two cents from the values given in the table. It would then be possible to learn whether students were able to recognize a biased market and react accordingly.) The play of the game is straightforward. Each team of students designs an initial foreign currency hedge. The instructor then rolls three dice, and the count of the pips (both red and white) determines the end-of-period exchange rate. The instructor then rolls two dice one more time to determine if there is a change in government that affects the banking system (there is a change if the sum of the pips on the two dice equals 3). This entire process takes less than one minute. The teams now calculate the net cost of their hedge. A second round is conducted, and the teams now have the choice of how to create a hedge for the next period. The process is repeated through several iterations to give teams the chance to use all types of hedges or gain experience with a specific type of hedge. The key learning event in the simulation is the debriefing session. The focus of the debriefing session should be on how and why certain hedging strategies worked. The results will indicate which strategies were the most and least profitable in this market session, but it should be pointed out that if the dice had fallen differently the results could have changed. If the instructor chose to bias the outcomes by adding/subtracting from each roll, it is necessary to discuss what happened and to determine whether any of the students noticed the bias and took actions accordingly. Students can be made to recognize that despite the best intentions of the money managers, the real world will have its own input on hedging performance. By allowing students the ability to make multiple decisions within a single period, they can see how different strategic and tactical plans may succeed or fail. CONCLUSION The Foreign Currency Hedging Simulation creates a dynamic environment in which students make decisions concerning hedges and see the results of those decisions. The simulation focuses on the decision making process, and several rounds can be completed within a single class session. The simulation does not require any detailed knowledge of the way in which the foreign currency exposure was created, so the simulation can be conducted with students who may not have a background in corporate finance. The focus is on managing an existing foreign exchange exposure. One important aspect of the simulation is that there are no winners or losers. The purpose of the exercise is to explore decision making techniques and see the results of specific decisions. The debriefing session allows the class members to discuss the nature of their decision making, and comparisons can be made between various teams in a noncompetitive environment. Everyone can learn from everyone else. The Foreign Currency Hedging Simulation gives instructors an interactive learning tool that can be used in this specific, and often confusing, area of finance. REFERENCES Alston & Chi (1990) “The Money Game: A Dynamic Simulation Including Random Shocks for Money and Banking Courses.” Association for Business Simulation and Experiential Learning. Papers and Conference Proceedings: Simulations, Games and Experimental Learning Techniques, Volume 17, 176. Becker (1997) “Teaching Economics to Undergraduates.” Journal of Economic Literature, Volume 35, 1347-1373. Bouton & Garth (1983) Learning in Groups. San Francisco, Jossey-Bass. Cooper & Mueck (1990) “Student Involvement in Learning: Cooperative Learning and College Instruction.” Journal of Excellence in College Teaching, Volume 1, 68-76. Hamm, Cabaniss, & Deaton (1990) “International Currency Fluctuations: Money$im, A Simulation.” Association for Business Simulation and Experiential Learning. Papers and Conference Proceedings: Simulations, Games and Experimental Learning Techniques, Volume 17, 84-87. Johnson & Johnson (1989) Cooperation and Competition: Theory and Research. Edina, Minnesota, Interaction Bank Company. Monahan & Goode (1997) “Financial Engineering of Global Investments: A Simulation.” Association for Business Simulation and Experiential Learning. Papers and Conference Proceedings: Simulations, Games and Experimental Learning Techniques, Volume 24, 80-81. Sharan, Kussel, Hertz-Lazarowitz, Bejarano, & Sharon (1984). Cooperative Learning in the Classroom: Research in Desegregated Schools. Hillsdale, New Jersey, Lawrence Eribaum Associates. Tansuhaj & Gentry (1988) “Introducing INMART: An International Marketing Simulation Game.” Association for Business Simulation and Experiential Learning. Papers and Conference Proceedings: Simulations, Games and Experimental Learning Techniques, Volume 15, 259-261. Thorelli (1997) “Musings on Business Game Performance Evaluation.” Association for Business Simulation and Experiential Learning. Papers and Conference Proceedings: Simulations, Games and Experimental Learning Techniques, Volume 24, 12-18. Zapalska & Brozik (1998) “The Market Game.” Journal of Business and Behavioral Sciences, Volume 4, 38-48. 311 Developments in Business Simulation and Experiential Learning, Volume 31, 2004 ATTACHMENT 1 STUDENT HANDOUT 312 Developments in Business Simulation and Experiential Learning, Volume 31, 2004 313 HEDGING FOREIGN EXCHANGE RISK BACKGROUND The purpose of foreign currency hedging is to minimize a firm’s exposure to changes in foreign exchange rates. There exist a number of ways for a firm to hedge this type of risk, each having its own particular characteristics. Properly constructed hedges can help assure the stability of a firm’s income stream while a lack of hedging can cause a firm various levels of financial distress. OVERVIEW You and your team members work for Consolidate Imports (CI). The firm imports consumer goods from all parts of the world and thus is often exposed to exchange rate risk. CI has begun buying merchandise from companies in the South American country of Parador. The government of Parador requires that all contracts be denominated in its home currency, the Sol, in order to protect domestic firms from exchange rate risk. If you want to do business in Parador, you will have to denominate all contracts in the Sol. Due to the quality and price of the merchandise, CI has chosen to do business in Parador even if it means assuming all the exchange rate risk. It is your job to design and monitor foreign currency hedges for CI’s business transactions in Parador. THE SOL The Sol is the national currency of Parador. The Sol (SL) floats freely against all other currencies, and the central government makes no attempt to influence its value in the international markets. The current exchange rate is SL1.000 = $1.005. The exchange rate between the Sol and the dollar has been relatively stable and is expected to remain that way. The distribution of expected exchange rates is shown below: THE FOREIGN EXCHANGE MARKET Due to the extent of trade between the United States and Parador, the foreign exchange markets are well developed. There are a number of international financial institutions and multinational banks that offer various types of financial contracts. A review of the markets indicates that the following contracts are available: Forward Contracts - The TransAmerican Financial Corporation (TFC) offers forward contracts of various maturities for the Sol. The contracts can be customized to any size, but TFC only offers fixed maturities. The current rates are: Developments in Business Simulation and Experiential Learning, Volume 31, 2004 All prices are given in $/Sol Length of contract Buy Sols Sell Sols 30-day .995 1.020 60-day .990 1.025 90-day .985 1.030 180-day .975 1.040 Futures and Options Contracts - The InterAmericas Commodity Exchange (ICE) offers futures contracts on the Sol. These contracts are for SL100,000 each and mature on the 20th of the month. The prices of currently available contracts are: All prices are given in $/Sol Maturity Month Price January 1.008 March 1.015 June 1.023 ICE also offers option contracts on the Sol. These contracts are for SL100,000 each and mature on the 15th of the month. The prices of currently available contracts are: All prices are given in $/Sol Maturity Month (Strike Price) Call Price Put Price March (1.000) .025 .020 June (1.000) .030 .035 Banking Relationships - CI has ongoing banking relationships with the First Consolidated Bank (FCB) in the United States and the Banco National de Parador (BNP) in Parador. FCB is CI’s principal US bank. Loans from this bank with maturities less than one year will cost CI 8%; deposits in appropriately liquid accounts will yield 4%. CI has recently opened its accounts with BNP, but at this time the Paradoran government is guaranteeing certain foreign accounts in order to attract investment to the country. CI can get short-term loans (less than two years) for 6%, and deposit accounts will return 4%. It must be noted that there has been news recently about political unrest in Parador. While the current government does not interfere with the banking system, if a new populist government comes to power, one of its first acts would be to nationalize the banking system. Should nationalization occur, any amount of money you had deposited in the Paradoran banks would be lost, but any amount of money that you had borrowed would not have to be repaid due to severing of diplomatic relations with the US. There is a 5% probability that such a change of government will occur. Any change in government would not affect the forward contracts offered by TFC or the futures and options contracts offered by ICE since these organizations are not in Parador. THE SITUATION Today is January 1st. Consolidated Imports has entered into a contract to purchase SL250,000 worth of merchandise from a Paradoran firm. The merchandise will be delivered in 90 days, and payment will be due on delivery. Your team has the responsibility for deciding whether to hedge CI’s exposure and, if so, exactly how to do it. You may choose to remain unhedged or use any instrument or combination of instruments to create the hedge. The only restriction you face is the firm’s general reluctance to become a currency speculator. It is understood that a hedge may not be “perfect”, but there should be no excess number of financial contracts beyond what is needed for the hedge. 314 Developments in Business Simulation and Experiential Learning, Volume 31, 2004 HEDGE FORMATION 1. Consider the firm’s situation and the state of the foreign exchange market. Determine how you will construct your hedge. 2. Use the form provided to describe the hedge. 3. The instructor will roll dice to determine the final exchange rate between the Dollar and the Sol. The dice will also determine if there is a change in government. 4. Calculate the final net cost of the hedge to Consolidated Imports. 5. Steps 1-4 will be repeated as time allows. 6. At the end of the simulation, groups will discuss their hedging philosophy and how well it worked in this market. 315 HEDGING FOREIGN EXCHANGE RISK ROUND: TEAM: EXPOSURE: SL250,000 AMOUNT TO BE HEDGED: DESCRIBE HOW THE HEDGE IS CONSTRUCTED: FINAL EXCHANGE RATE: $/SL NET PROCEEDS TO CI (show calculations): 316 317 ATTACHMENT 2 EXCHANGE RATES FROM DICE ROLLS ($/SOL) Value of Red Die 1 2 3 4 5 6 2 .955 .975 1.035 1.035 1.035 .98 3 .96 .975 .985 1.035 1.035 1.015 4 1.00 .985 .985 .985 .985 .98 5 .965 .99 .99 .99 .99 .98 Sum of 6 1.00 1.00 1.00 1.015 1.015 1.015 Black 7 .97 1.04 .975 1.005 1.005 1.005 Dice 8 1.01 1.01 1.01 .995 .995 .995 9 1.045 1.02 1.02 1.02 1.02 .98 10 1.01 1.025 1.025 1.025 1.025 1.03 11 1.05 1.025 1.03 1.03 1.03 .995 12 1.055 1.035 1.035 1.03 1.03 1.03 Table of Contents Volume 31, 2004 Controlling the Complexity and Orenting Target Groups by a Modular, Server-Based Business Game System Learning Network Demonstration: Delivering Business Education in a Distance Learning Environment Economic Evolution, Human Capital Investment, and Adult Distributed Electronic Learning: A Literature Review Designing a Globalization Simulation to Teach Corporate Social Responsibility Developing and Teaching an Online / In-Class Hybrid: A Demonstration A Model for Evaluating Online Instruction An Evaluation of a Distributed Learning Course: A Students'-Eye Perspective Blended Learning Strategy Improved Business Writing Skills How to Receive and Process Attachemnts while Greatly Reducing the Risk of Viruses and Trojans Introducing Online Components to a Class: How to Increase teh Likelihood of Success Teaching Strategic Communications Online: Using Learning Outcomes to Develop a Case-Based Course Implementing Distance Approaches to Education: A Panel Discussion for ABSEL: Las Vegas, 2004 MANDI: Learning Management Through Field Sales Experience An International Capital budgeting Experiential Exercise A Primer To Combating Terrorism: Playing It Safe While On Overseas Assignment (An Experiential Exercise) Integrating The Business Curriculum With A Comprehensive Case Study: A Prototype The Case Brief: A Model For Case Analysis, Writing And Discussion Technology Infused Pedagogy And Delivery – A Sure Bet? A Proposal For Panel Discussion Absel Conference 2004 Research Strategy And The Bkl: Getting The Most From The Absel Archives Simple But Effective: Rediscovering The Class Discussion Needle And Thread: An Activity For Examining Various Management Behaviors A Customized Excel Data Analysis System For Use In Undergraduate Marketing Research Team Leader Selection - Does It Matter? The Power Of Perspective: Reframing Your Framing Skills For Innovative Instruction In Leadership And Influence Exercise: How Should Merit Raises Be Allocated? An Online Situation For Problem-Based Learning In A Junior-Level Management Course The Eden Alternative As A Roadway For Change: A Service Learning Quality Improvement Project Avoiding Catastrophe: The Role Of Individual Accountability In Team Effectiveness Omega Systems: A Change Management Exercise The Risks And Rewards Of Providing Students A Structured Cheating Opportunity Experimentation With Assessment Techniques: A Proposal For Panel Discussion Using A 2 - Page Case To Introduce Concepts Of Business Strategy Interactive Session The Integration Of Appreciative Inquiry And Experiential Learning For Peak Performance Appreciative Inquiry Case Story: New York City Leadership Challenge Individual Achievement Versus Team Performance: An Empirical Study With Business Games Some Strategists Don't Learn Or Can't Learn Computer Simulation: A Design Architectonic On The Value Of Bugs In Simulation Environments Online Sales Forecasting With The Multiple Regression Analysis Data Matrices Package Simulation Exercises And Problem Based Learning: Is There A Fit? A Study Of Business Game Stock Price Algorithms Assessing Individual Performance In A Total Enterprise Simulation Information Use In A Business Game Determining The Value Of A Firm Unsorting Algorithms For An Ordered List And Its Application To Business Simulations Teaching Public Finance Management Through Simulation Antecedents Of Game Performance Student Expectations Of Classroom Teaching Practices In Developing And Presenting Course Information In Hong Kong Implementation And Impacts Of The Balanced Scorecard: An Experiment With Business Games Impact: Shocking The Legacy Mindset Implementation Of The Eepad Framework Of Business Processes In An Accounting Information Systems Course Are Business Games Really Delivering What Students Are Led To Believe?? Reporting Lessons Learned: What Gets Reported; Who Gains Value Teacher Expectations Of Classroom Teaching Practices In Developing And Presenting Course Information In Hong Kong Student Reactions To The Use Of A Computer-Based Simulation As An Integrating Mechanism For A Mba Curriculum A Cognitive Investigation Of The Internal Validity Of A Management Strategy Simulation Game The Casino Challenge: Making Simulation Delivery A Safe Bet! Accounting For Company Reputation: Variations On The Gold Standard Foreign Currency Hedging: A Simulation The Influence Of Variables Easily Controlled By The Instructor/Administrator On Simulation Outcomes: In Particular, The Variable, Reflection. Absel Awareness Among Business School Faculty Validating Business Simulations: Does High Market Share Lead To High Profitability? Simulation Debriefing Procedures Coaching And Business Simulations: A Formula For Success? A Seminal Inventory Of Basic Research Using Business Simulation Games The Influence Of Scorecard Evaluation On Decisions And Outcomes