Cash balance calculation

Consider a customer who wants to finance an acquisition of a Taiwanese enterprise. The plan is to borrow USD 0.5 mln for 5 years and repay the loan and interest from the income of the enterprise. The income forecast is TWD 5.2 mln per year. This is a lucrative opportunity, unless Taiwanese dollar depreciates against US dollar within 5 years. On the other hand, if US dollar depreciates, the gain will be even greater.

The customer wants some protection against depreciation of the Taiwanese dollar. Our salesperson offers to hedge a part of the exchange rate risk. She will sell five FX forward transactions whose expiry dates coincide with loan repayments. In other words, each year the customer will pay a fixed amount in TWD and receive a fixed amount in USD. The amounts are determined according to today's exchange rate and interest rates in USD and TWD, so today's mark-to-market value of the FX forwards is zero.

To demonstrate the effect of the FX forwards, the salesperson uses MarketSimulator's ability to calculate the cash balance of a portfolio. Cash balance is the sum of all cashflows (paid and received until a certain date), plus the remaining value of the portfolio. Essentially, cash balance is the accumulated wealth of the customer.

The salesperson enters the projected income of the enterprise into MarketSimulator, along with the loan repayments and the proposed FX forwards (these are shown under "Hedge" in the tree below).

Next, the salesperson shows the customer what his revenues will look like under favourable and unfavourable conditions. Here, we define favourable as the 95-percentile of the cash balance, and unfavourable as the 5-percentile of the cash balance (in other words, there is only 5% chance that matters get even worse than in our unfavourable scenario).

The graphs below show the development of the customer's wealth with and without the FX forward transactions. The top and bottom graphs show the situation without any protection from exchange rate fluctuation: there can be a great upside (if TWD appreciates), but also a huge downside (if TWD depreciates). The two graphs in the middle (the blue and black ones) show the favourable and unfavourable case when the customer has purchased the FX forwards. We see that the potential downside is very limited. The potential upside is also smaller, of course.

With these graphs the salesperson will demonstrate the risk and reward of her proposition to the customer. More importantly, she will be able to adjust the FX forward parameters and recalculate the cash balance for a different proposition.