FINM3403-T6 Sols-Foreign Exchange Exposure

Topic 6 Foreign Exchange Exposure I – Solutions(Reading Eiteman et al. Chapters 7 & 8)Transaction Exposure1. How would you define transaction exposure? How is it different from economicexposure?Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well defined and short-term.2. Discuss and compare hedging transaction exposure using the forward contractvs. money market instruments. When do the alternative hedging approaches produce the same result?Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.3. Suppose your company has purchased a put option on the German mark tomanage exchange exposure associated with an account receivable denominated in that currency. In this case, your company can be said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.Your company in this case knows in advance that it will receive a certain minimum dollar amount no matter what might happen to the $/DM exchange rate. Furthermore, if the German mark appreciates, your company will benefit from the rising mark.4. Should a firm hedge? Why or why not?In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.5. Cray Research sold a super computer to the Max Planck Institute in Germany oncredit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months.(a) What is the expected gain/loss from the forward hedging?Expected gain/loss ($) = 10,000,000*(1.10 – 1.05)= $500,000 gain(b) If you were the financial manager of Cray Research, would you recommendhedging this € receivable? Why or why not?There is no easy answer here. Hedging is expected to increase the dollar receipt by $500,000. Remember this analysis is conducted ex-post. It depends on the degree of my risk aversion.(c) Suppose the foreign exchange advisor predicts that the future spot rate will bethe same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?Since I eliminate risk without sacrificing dollar receipt, I would be more likely to hedge.6. You plan to visit Geneva, Switzerland in three months to attend an internationalbusiness conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.(a)Calculate your expected dollar cost of buying SF5,000 if you choose to hedgevia call option on SF.Total option premium = (0.05)(5000) = $250. In three months, $250 is worth $253.75 =$250 (1.015). At the expected future spot rate of $0.63/SF, which is less than theexercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy SF5,000, you expect to spend $3,150(=0.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of$3,150 and $253.75, i.e., $3,403.75.(b) Calculate the future dollar cost of meeting this SF obligation if you decide tohedge using a forward contract.$3,150 = (0.63) (5,000).(c) At what future spot exchange rate will you be indifferent between the forwardand option market hedges?$3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 = $3,200 + $253.75.7. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. AirFrance will be billed €20 million payable in one year. The current spot rate is $1.05/€ and the one-year forward rate is $1.10/€. The annual interest rate is 6.0 percent in the U.S. and 5.0 percent in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge its exchange exposure.(a) It is considering two hedging alternatives: sell the euros proceeds from the sale forward or borrow euros from Credit Lyonnaise against the euro receivable. Which alternative would you recommend? Why?In the case of forward hedge, the future dollar proceeds will be (20,000,000) (1.10) = $22,000,000.In the case of money market hedge (MMH), the firm has to first borrow the PV of its franc receivable, i.e., 20,000,000/1.05 = €19,047619. Then the firm should exchange this franc amount into dollars at the current spot rate to receive: (€19,047619) (1.05) = $20,000,000, which can be invested at the dollar interest rate for one year to yield: $20,000,000 * (1.06) = $21,200,000.Clearly, the firm can receive $800,000 more by using Forward hedge.(b) Others things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?According to IRP, F = S (1+i$)/(1+i€). Thus the “indifferent” forward rate will be: F = (1.05) (1.06)/(1.05) = $1.06/€.8. The Melbourne Tile Company has received an order from a Korean manufacturing company for machinery worth Won 1,120,000,000. The export sale would be denominated in Korean won. The Melbourne Tile Company’s opportunity cost of funds is 14%. The current spot rate is Won 800/$, and the won in the forward market sells at a discount of 10% per annum. However, the finance staff of the Melbourne Tile Company forecasts that the won will drop only 8% in value over the next year. The Melbourne Tile can borrow won in Seoul at 10% per annum. (i)If the Melbourne Tile Company does not hedge and assuming that your financestaff are correct in their forecasts, what will be its dollar proceeds?(Won800/$)/0.92=Won 869.57Won1,120,000,000/((Won869.57/$)x(1.14)) = $1,129,824(ii)If the Melbourne Tile Company hedges in the money market, what will be its dollar proceeds?Borrow PV of Won1,120,000,000 in Seoul today @ 10%:Won1,120,000,000/1.10 = Won1,018,182,000Exchange to $ @ spot rate of Won800/$:Won 1,018,182,000/(Won800/$) = $1,272,728 today(iii)The Melbourne Tile could also cover its transaction exposure by purchasing a put option with a strike price of Won 800/$ for a premium cost of 1.25%. If this option were eventually exercised, the Melbourne Tile would net how much on its export sale?The premium-cost for options, paid today, is:Won1,120,000,000x0.0125/(Won800/$) = $17,500When we exercise the options, we sell the Won @Won800/$:Won1,120,000,000/(Won800/$) = $1,400,000 at the end of the yearPresent value of those proceeds, at a 14% U.S. cost of capital:$1,400,000/1.14 = $1,228,070Net of the premium costs, the U.S. dollar proceeds are:$1,228,070 - $17,500 =$1,210,5709. Dell Computer produces its machines in Asia with components largely importedfrom the United States and sells its products in various Asian nations in local currencies.(a) What is the likely impact on Dell's Asian profits of a strengthened dollar?Explain.Dell's dollar costs largely stay fixed whereas its dollar revenues will decline. Thus, a strengthened dollar reduced Dell's dollar profits on its Asian sales.(b) What hedging technique(s) can Dell employ to lock in a desired currencyconversion rate for its Asian sales during the next year?Dell can use forward or futures contracts to sell the local currencies forward against the dollar in an amount equal to its projected annual local currency sales. It can also buy put options on the various Asian currencies that it can exercise in the event of dollar appreciation.(c) Suppose Dell wishes to lock in a specific conversion rate but does not want toforeclose the possibility of profiting from future currency moves. What hedging technique would be most likely to achieve this objective?Buying put options on the local currencies would allow Dell to offset its currency losses with gains on its put options if the local currencies depreciate against the dollar. If the local currencies remain stable or strengthen, Dell would just allow the options to expire unexercised and convert its local currency revenues at the higher spot rates.(d) What are the limits of Dell's hedging approach?This approach will cover Dell for the first year. But if the dollar strengthens, when Dell goes to roll over its forwards or options to hedge the next year's revenues, it will pay a price for these contracts that reflect the devalued exchange rates of the local Asian currencies.10. The Montreal Expos are a major-league baseball team located in Montreal,Canada. What currency risk is faced by the Expos, and how can this exchange risk be managed?Payroll costs account for the lion's share of baseball costs. The Expos have currency risk since they pay their players in U.S. dollars while their principal source of income, from home game ticket sales, is in Canadian dollars. This currency mismatch means trouble when the U.S. dollar appreciates relative to the Canadian dollar. Most importantly, salaries for Expo ballplayers are based on the salaries these players would earn in the United States; they are not based on Canadian salaries.11. In order to eliminate all risk on its exports to Japan, a company decides to hedgeboth its actual and anticipated sales there. What risk is the company exposing itself to? How could this risk be managed?The company faces uncertainty as to what its future yen sales revenue will be. This uncertainty stems from quantity risk, the risk that those future sales will not materialize, and price risk, the uncertainty as to the yen prices it can expect to realize in Japan. If it uses forward contracts to hedge its uncertain future yen sales revenue, it faces the risk that it will overhedge, winding up with yen liabilities not offset by yen assets. The company can protect itself by using forward contracts to hedge the certain component of its expected future yen sales then hedging the remainder of its projected sales revenue with currency options.12. Instead of its previous policy of always hedging its foreign currency receivables,Sun Microsystems has decided to hedge only when it believes the dollar will strengthen. Otherwise, it will go uncovered. Comment on this new policy.Sun is engaging in selective hedging, which is really speculation. Sun faces the risk that it will be unhedged when foreign currencies weaken and be hedged when they strengthen. The purpose of hedging is to reduce risk, not to boost profits.13. DKNY owes Ptas 70 million in 30 days for a recent shipment of Spanish textiles.It faces the following interest and exchange rates:Spot rate: Ptas 130/$Forward rate (30 days) Ptas 131/$30-day put option on dollars at Ptas 129/$ 1% premium30-day call option on dollars at Ptas 131/$ 3% premiumU.S. dollar 30-day interest rate (annualized): 7.5%Peseta 30-day interest rate (annualized): 15%a. What is the hedged cost of DKNY's payable using a forward market hedge?In other words, what dollar cost of the payable can DKNY lock in using the forward contract? By buying pesetas forward, DKNY can lock in a dollar cost of $534,351 (70,000,000/131).b. What is the hedged cost of DKNY's payable using a money market hedge? DKNY can hedge its payable by borrowing the dollar equivalent of the present value of the Ptas 70 million payable, which equals Ptas 69,135,802 (70,000,000/1.0125), converting the dollars to pesetas at the current spot rate, and investing the proceeds at the 1.25% monthly peseta interest rate (15%/12). The Ptas69,135,802 amount translates into a dollar amount of $531,814 at the current spotrate of Ptas 130/$ (Ptas 69,135,802/130). This investment is financed by borrowingthese dollars at the monthly rate of 0.625% (7.5%/12). At the end of 30 days, DKNYwill pay off this dollar loan. The cost of doing so is $535,138 ($531,814 x 1.00625). The result from this money market hedge is the equivalent of buying forward thePtas 70 million at a forward rate of Ptas 130.81 (70,000,000/535,138). From thestandpoint of the treasurer, this is a worse rate than could be realized directly in theforward market (as evidenced by the fact that the forward market hedge yields acost that is $787 lower than the cost of the money market hedge).c. What is the hedged cost of DKNY's payable using a put option?By buying a put option on dollar with Peseta Receipt, DKNY can lock in a cost of$548,021 = the sum of the 1% put premium of $5,385 (0.01 x 70,000,000/130) plus the$542,636 (70,000,000/129) cost of buying pesetas through the put option at a rate ofPtas 129/$. (Notice that a put option on dollars with peseta receipt is exactly the same as a call option on pesetas. Hence, the terms can be used interchangeably as long as you bear in mind which currency is being bought and which is being sold). Although it looks as if the put option costs $13,670 more than the forward contract, these costs are not strictly comparable. The reason is that the put option gives DKNY the option to buy pesetas in the spot market in 30 days if the spot rate of the dollar at that time exceeds the exercise price of Ptas 129/$. Hence, the $542,636 cost is the maximum cost of using a put option. On the other hand, with a forward contract, DKNY must buy pesetas at Ptas 131/$ even if the spot rate at time of settlement is lower at, say, Ptas 133/$. The value of this option accounts for the 1% premium that DKNY must pay to acquire the put option.14. In your role as an advisor to the CFO of Watermelon Technologies you havebeen asked to write a report on why hedging might reduce agency costs. Whileyou have no problems convincing him that bondholders would prefer the firmhedge exchange rate risk, what arguments would you put forward to persuadehim that he has a personal stake in the decision as well?Hedging reduces AGENCY COSTS. Here you need to focus on the conflict ofinterest between shareholders and the managers of the firm. The wages and bonusplan of managers depend on the performance of the firm. If the firm does not hedge,the CFO is likely to insist on higher wages as a risk-premium for the extra risk that hebears.15. Beach Comber, the mayor of Sandy Beach in Australia, has received bids fromthree dredging companies for a beach renewal project. The work is carried out in three stages, with partial payment to be made at the completion of each stage.The current foreign currency spot rates are 1.6 £/AUS$, 5.5 €/AUS$, and 1.3 C$/AUS$. The effective AUS$ interest rates that correspond to the completion of each stage are the following: r0,1 = 6.00 percent, r0,2 = 6.25 percent, and r0,3 =6.50 percent. The companies’ bids are shown below. Each forward ratecorresponds to the expected completion data of each stage.Company stage 1 stage 2 stage 3London Dredging £ 1,700,000 £ 1,800,000 £ 1,900,000 Forward rate £/AUS$ F0,1 = 1.65 F0,2 = 1.70 F0,3 = 1.75 Marseille Dredging € 5,200,000 € 5,800,000 € 6,500,000 Forward rate €/AUS$ F0,1 = 5.50 F0,2 = 5.45 F0,3 = 5.35 Vancouver Dredging C$ 1,300,000 C$ 1,400,000 C$ 1,500,000Forward rate C$/AUS$ F0,1 = 1.35 F0,2 = 1.30 F0,3 = 1.25(a) Which offer should Mayor Comber accept?a)Company stage AUS$ value of bid at time 0London Dredging 1 1,700,000/1.65x1/1.06 = 971,9842 1,800,000/1.70x1/1.0625 = 996,5403 1,900,000/1.75x1/1.065 = 1,019,450Total time-0 value of the bid 2,987,974Marseille Dredging 1 5,200,000/5.5x1/1.06 = 891,9382 5,800,000/5.45x1/1.0625 = 1,001,6193 6,500,000/5.35x1/1.065 = 1,140,801Total time-0 value of the bid 3,034,358Vancouver Dredging 1 1,300,000/1.35x1/1.06 = 908,4562 1,400,000/1.3x1/1.0625 = 1,013,5753 1,500,000/1.25x1/1.065 = 1,216,761Total time-0 value of the bid 3,048,791Mayor Comber should accept the bid made by London Dredging.(b) Was he wise to accept the bids in each bidding company’s own currency?Please explain briefly.Yes. The mayor can hedge using a standard forward contract. If the bids had been offered in for instance in C$, each bidder would have to use an expensive hedge or bear substantial risk during the bidding process. This would likely cause them to increase their bids.16. Samuel Samosir works for Peregrine Investments in Jakarta, Indonesia. Hefocuses his time and attention on the U.S. dollar/Singapore dollar ($/S$)crossrate. The current spot rate is $0.6000/S$. After considerable study, he has concluded that the Singapore dollar will appreciate versus the U.S. dollar in thecoming 90 days, probably to about $0.7000/S$. He has the following options onthe Singapore dollar to choose from:Option Strike Price PremiumPut on S$ $0.6500/S$ $0.00003/S$Call on S$ $0.6500/S$ $0.00046/S$(a) Should Samuel buy a put on Singapore dollars or a call on Singapore dollars? Since Samuel expects the Singapore dollar to appreciate against the U.S. dollar, he should buy a call on Singapore dollars.(b) Using your answer to (a), what is Samuel’s break-even price?Samuel’s breakeven price (assuming no discount rate) is $0.65000+$0.00046 =$0.65046.(c) Using your answer to (a), what are Samuel’s gross profit and net profit (including the premium) if the spot rate at the end of the 90 days is indeed $0.7000/S$?Samuel’s gross profit, if the spot rate is $0.7000/S$, will be $0.7000−$0.6500 = $0.05000.His net profit would be $0.05000−$0.00046 = $0.04954.Translation Exposure1. Explain the difference in the translation process between the monetary/non-monetary method and the temporal method.Under the monetary/non-monetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/non-monetary method will typically provide the same translation.2.How are translation gains and losses handled differently according to the currentrate method in comparison to the other three methods, that is, the current/non-current method, the monetary/non-monetary method, and the temporal method? Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement. The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.3. How does translation (or accounting) exposure differ from economic exposure?(Past Exam Question) Some of the differences include:Economic exposure is concerned with cash flows and not accounting values.Consequently, a change in the accounting value due to translation does not affect the firm’s cash situation and market value.Economic exposure is a forward-looking concept – focuses on future cash flows.A/Cing exposure relates to past decisions as reflected in the firm’s financial statements.Economic exposure considers ALL cash flows and sources of value, whether they are recorded or not in the financial statements. A/Cing exposure looks only at items on the balance sheet or income statement. It ignores off-balance sheet contracts, and cash flows from future operations.4. What factors affect a company's translation exposure? What can the company doto affect its degree of translation exposure?The factors affecting a company's translation exposure include the currency of the primary economic environment in which the company (or its affiliate) doesbusiness, the currency in which it invoices its sales, the currency in which itnegotiates to buy, the currency denomination of its borrowings, the currencydenomination of the securities in which it invests surplus cash, and the location ofits customers. This list suggests the actions that a company can take to affect its degree of translation exposure: borrow, invest, and invoice both sales and purchasesin the local currency. It also has some degree of control over which customers toserve -- foreign or domestic -- but this decision should be based on economicprofitability rather than its impact on translation exposure.5. What is the basic translation hedging strategy? How does it work?The basic translation hedging strategy involves increasing hard-currency assets anddecreasing soft-currency assets, while simultaneously decreasing hard-currencyliabilities and increasing soft-currency liabilities. The specific techniques used tohedge a particular translation exposure all involve establishing an offsettingcurrency position (e.g. by means of a forward contract) such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge.6. Paragon U.S.'s Japanese subsidiary, Paragon Japan, has exposed assets of ¥8billion and exposed liabilities of ¥6 billion. During the year, the yen appreciates from ¥125/$ to ¥95/$.a. What is Paragon Japan's net translation exposure at the beginning of the year inyen? in dollars?Paragon Japan has net translation exposure of ¥2 billion (¥8 billion - ¥6 billion). Converted into dollars, this figure yields translation exposure of $16 million (2 billion/125).b. What is Paragon Japan's translation gain or loss from the change in the yen'svalue?At the end-of-year exchange rate, Paragon Japan's translation exposure equals $21,052,632 (2 billion/95). The net result is a translation gain for the year of $5,052,632 ($21,052,632 - $16,000,000).c. At the start of the next year, Paragon Japan adds exposed assets of ¥1.5 billionand exposed liabilities of ¥2 billion. During the year, the yen depreciates from ¥95/$ to ¥130/$. What is Paragon Japan's translation gain or loss for this year?What is its total translation gain or loss for the two years?Paragon Japan's new translation exposure at the start of the year is ¥1.5 billion ( ¥2 billion + ¥1.5 billion - ¥2 billion). Given this exposure and the exchange rate change during the year, its translation loss for the year equals $4,251,012 (1,500,000,000 x (1/95 - 1/130)). Over the two-year period, Paragon Japan has realized a translation gain of $801,620 ($5,052,632 - $4,251,012).。