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HEDGING WITH FOREIGN CURRENCY FUTURES

AT TRANSCEND INC

Benjamin L. Dow III, Southeast Missouri State University

David A. Kunz, Southeast Missouri State University

CASE DESCRIPTION

The primary subject matter of this case is hedging foreign currency exchange rate risk using
foreign currency futures contracts. Secondary issues examined include assessing transaction
exposure and estimating profit margin exposure. The case requires students to have an introductory
knowledge of accounting, statistics, finance and international business thus the case has a difficulty
level of four (senior level) or higher. The case is designed to be taught in one class session of
approximately 3 hours and is expected to require 4-5 hours of preparation time from the students.

CASE SYNOPSIS

Transcend Inc is a US based company specializing in corporate travel services. Recent

product line additions have exposed the company to more significant foreign currency exchange rate
risks. In addition, the unique structure of Transcend’s business model has led the company president,
Mike Travis, to consider using foreign currency futures contracts in addition to traditional forward
currency hedges. Transcend would like an evaluation of the company’s increased foreign currency
exposure and a proposed strategy for eliminating unwanted exchange rate risk before the next
earnings conference call.

BACKGROUND

Employees engaged in corporate sales make up approximately 12% of the fulltime

workforce in the United States. Corporations spend over one trillion dollars annually on sales
force expenditures, more than they spend on any other promotional method. Given the high cost
and importance of the personal selling function, a key managerial concern is about motivating
people to achieve higher levels of performance. Incentives like sales contests are generally seen
as an important tool to motivate sales people to achieve goals that surpass those associated with
normal compensation, enhance job satisfaction, and increase corporate profits. Sales incentives
promotion is an industry that exceeds $150 billion annually. Awards associated with sales
contests generally fall into one of three categories — cash, merchandise, and travel. Growth in
travel awards exploded during thel 990’s, only to drop off as the technology industry fell apart in

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Page 74

2000 and the 9/11 terrorist attacks of 2001 made travel as a reward less appealing. However, the
all-expense paid vacation for employees achieving specific benchmarks is making a comeback as
a popular incentive award. The Incentive Marketing Association estimates that corporate
America spent about $40 billion on travel rewards alone in 2011. In addition, there has been a
significant change in the destinations and type of activities people are doing with incentive travel.
The trend in this industry is shifting to a desire for more adventurous international travel options.
Transcend Inc is an Atlanta based company specializing in corporate travel services.
Their focus is primarily on incentive initiatives, customer loyalty programs, and meetings and
event management. Founded in 1986 by Mike Travis, Transcend Inc has two main divisions. The
corporate event group is a higher volume/lower margin division that specializes in large group
travel outings, such as training seminars, conferences, and annual meetings. The incentive travel
group is a lower volume/higher margin division that provides travel packages mostly associated
with sales contests, customer loyalty programs, and other reward based promotions. In a typical
sales contest, a company may set a specific goal for its sales force. Possible objectives may be to
increase sales, generate new accounts, launch new products, liquidate inventory or expand into
new territories. The company will then define precisely what the sales force needs to accomplish,
whether its percentages, number of units, profits or some other concrete measurement and
employees who achieve stated goals will earn rewards such as travel packages.

THE SITUATION

By and large, the incentive travel division at Transcend works off a catalog business. The
main catalog is published twice a year (January and July) and allows customers to choose from a
variety of travel rewards associated with employee incentive programs. Destination trips are
grouped into tier levels and vouchers for tier levels are sold from the catalog at a guaranteed
price. For example. Tier One vouchers are currently priced at $1000 per person and included
popular domestic destinations such as Orlando, Las Vegas, and San Diego and usually
incorporate activities such as spa treatments or rounds of golf. Higher tier levels, offered at
higher prices, include both domestic and international travel destinations such as New York,
Hawaii, Europe and Asia. Between the various destinations offered at each tier level, the current
catalog contains over 60 destination options.
A typical client of Transcend might design a sales incentive program where points are
awarded for achieving specific sales goals. The more points an employee earns, the higher the
tier voucher. For example, a Transcend client might have a sales force of 100 employees. It is
possible that 20 out of 100 may earn enough points to be eligible for a Tier One voucher award.
10 out of 100 might earn a Tier Two voucher, and 5 out of 100 may be eligible for Tier Three
vouchers. The company would then purchase 35 travel vouchers (20 Tier One, 10 Tier Two, and

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5 Tier Three) from Transcend. Eligible employees awarded vouchers would later redeem them
for their preferred destination within a year with Transcend handling all of the travel
arraignments.
When a new catalog is printed, the travel division does not know exactly how many
vouchers will ultimately be sold nor do they know which trips offered within tier levels will
ultimately be chosen. However, Transcend meets regularly with marketing and operations
managers to discuss sales forecasts and events that might affect sales. In addition, these managers
are responsible for monthly sales forecasts, which provided good estimates of expected volume.
Mike Travis, CEO of Transcend Inc, talks almost daily with Amanda Martin, vice
president of the incentive travel division. Most of their recent discussions have dealt with
properly managing the newer foreign travel package options among the higher tier levels in the
company’s upcoming January 2012 catalog. Martin has been working for the last 2 months with
Brazilian hotel operators and tour guides on a new package that covers the Rio de Janeiro
Carnival in Brazil. The popularity of Brazil as a travel destination has increased substantially in
the last 5 years with over 5 million visitors in 2010. With the recent announcements of the 2014
World Cup and 2016 Summer Olympics in Brazil, Transcend is hoping to develop relationships
with Brazilian hospitality companies to include additional travel packages in the near future.
Transcend would like to include a package that includes the Brazil Carnival in 2013 and later add
World Cup options in 2014 and eventually Summer Olympics in 2016. One of the main concerns
Transcend has is foreign currency exchange rate risk. Award recipients who choose Brazil as a
travel destination implies that Transcend will receive payment in US dollars, but incur costs in
Brazilian real. If the Brazilian trips turned out to be as popular as Martin envisioned. Transcend
would face significant exchange rate risk and potential margin erosion if the Brazilian real were
to significantly strengthen in value.
Foreign currency exchange rate risk itself does not worry Travis, as he is familiar with
hedging techniques frequently used by the corporate event division. For example, the corporate
division organized a 400 participant annual meeting for a client in Paris last year. Although the
client paid Transcend in US dollars, the expenses incurred by Transcend were in Euros. Because
of the size of the European expense, the corporate division simply purchased Euros forward
equivalent to 90% of projected expenses once the contract was signed. Because the timing and
approximate amount of Euros needed was known 10 months in advance, the forward contract
eliminated a majority of exchange rate risk that would arise if the Euro strengthened over the
exposed time period. Unfortunately, in offering a new destination for the first time, the amount of
currency exposure to be hedged will not be large enough to use forward contracts. However, the
exchange rate risk is significant enough to impact margins for the Incentive Travel division.
Transcend explained the difference to Martin using a few simplifying assumptions.

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Our next catalog will be published on January l, 2012. You have included the Brazil
Carnival offering under the Tier 3 category based on current exchange rates. Your team will sell
travel vouchers out of the catalog over the next few months. However, the final volume of vouchers
sold will not be known until July 1, 2012. All vouchers sold are priced in US dollars. However,
eligible employees will redeem their vouchers for various travel destinations throughout the
remainder of the year. We have included a special provision in the Carnival option stipulating that
recipients who choose the Carnival option must do so by October 15th,
2012. We will have to pay deposits of approximately one half of the total on October 31st, 2012,
with the remainder of the payments to be made on January 31st, 2013. We have to set our prices on
January 1, 2012. The total number of vouchers sold will be known on July 1, 2012. The total number
of Carnival trips redeemed will be known by October 15lh, 2012. Deposits in real will have to be paid
on October 31s', 2012 and the final payment in real will be made on January 1st,
2013.

300 days of FX exposure-

360 days of FX exposure
1-1-12 7-1-12 10-15-12 10-31-12 12-31-12
Catalog Vouchers sold Total Carnival Initial deposit Final payment
distributed US$ revenues vouchers redeemed in R$ made in RS made
received known

Travis explained further:

Let’s take a look at the Tier 3 offerings and make some simplifying assumptions. The options now
include New York, San Francisco and Brazil. We sold about 2,000 Tier 3 (priced at S3,000) vouchers
over the last 6 months out of the July 2011 catalog. Our costs average about $2,300 per domestic trip
and our anticipated costs are 4,000 RS for the Carnival in Brazil trip. If we assume the same level of
sales for the January 2012 catalog and your marketing research is correct in predicting a 20%
acceptance rate on the Carnival trip, then we can assume about 400 Carnival trips will be selected.
We can estimate that we will need to buy a total of 1.6 million RS over the next year. 800,000
RS will need to be purchased by October 31st, 2012 and the remaining 800,000 RS will need to be
purchased on December 31s', 2012. Given current exchange rates of about SO. 53/1BRL, the profit
margins are slightly higher on the Brazilian offering compared to the domestic offerings. However if
the real were to strengthen to its 52 week high of S0.65/1BRL, our costs per trip would rise from
$2,120 to S2,600 with gross margins eroding from over 29% to just over 13%). Of course, exchange
rate risk works both ways, and if the real were to weaken over the next 12 months, our margins
would improve. However, the incentive travel division needs gross margins to average 20% along
with target revenues to meet your division forecast. 1 would suggest that you take a look at using
foreign currency futures contracts as means of

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hedging the exchange rate exposure. I am not saying we have to hedge this risk hut we should at least
determine our exposure first and then decide if we would like to use futures contracts as a part of our
risk management strategy.

After the meeting with Travis was over, Martin went back to her office to consider the
best course of action for including the Brazilian trips. She needed the Carnival trips to be
included in the catalog in order to develop relationships with Brazilian hospitality providers.
Developing relationships today should pay big dividends when it comes to putting together the
very best packages for the 2014 World Cup and 2016 Olympics in Brazil. If she can differentiate
Transcend from other corporate travel providers in this area, Transcend might be able to gain
market share in the already competitive environment. She had spent a lot of time putting together
the Carnival package and her instincts led her to believe the Brazil offerings could drive top line
revenue growth for at least the next four years. However, Martin also knew that her
compensation was linked with bottom line profits not top line sales. Before any major bonus
compensation was paid. Martin would need foreign currencies to remain stable or weaken
relative to the dollar if the currency risk was not hedged. Top line revenue growth is nice, but not
at the expense of margin compression. Martin would need to access the risk associated with the
current Carnival in Brazil offering and devise an appropriate hedging strategy if required.

SUGGESTED REFERENCES

Chicago Mercantile Exchange, http://www.cmegroup.com.

Financial Times, http://www.ft.com.
Madura, Jeff, International Financial Management, 1 1 E d i t i o n , Thompson/Soulh-Western, 2012.OANDA.com.
http://www.oanda.com.
Robin, J. Ashok., International Corporate Finance, Mc-Graw Hill, 2010.

Journal of the International Academy for Case Studies, Volume 19, Number 5, 2013