Daily Archives: August 17, 2011


Q1: How would you define transaction exposure? How is it different from economic exposure?

Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly. The magnitude of transaction exposure is the amount of foreign currency that is receivable or payable.  Economic exposure is the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. The firms value already reflects the anticipated changes in exchange rates.  Both Transaction and economic exposures are cash exposures. The difference is that transaction exposure is caused by individual transactions of accounts receivable or payable, while the economic exposure is uncontrollable and affects the total value of the firm. An example of economic exposure is that a change in the exchange rate can change the overall competitiveness of the firm internationally.

Q4: What are the advantages of a currency options contract as a hedging tool compared with the forward contract?

A forward contract occurs when a firm sells its foreign currency receivables or buys its foreign currency payable forward to eliminate exchange risk exposure. It allows the company to lock in a future exchange rate today so that profits will not be affected by changes in the exchange rate. Forward contracts completely eliminate exchange exposure, but the firm has to forgo the opportunity to benefit from favorable changes in the exchange rate. ¬†Currency options, on the other hand, provide a flexible ‚Äúoptional‚ÄĚ hedge against exchange risk exposure. Currency options allow firms to limit the downside risk while preserving the upside potential. If the dollar depreciates the firm can use the currency option, while if the dollar appreciates the firm can allow the option to expire and use the spot rate. The firm pays for this flexibility with an option premium.

Q6: Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?

In a ‚Äúperfect‚ÄĚ capital market¬†Exchange exposure management at the corporate level is redundant when the stockholders can manage the exposure themselves. ¬†What matters in firm valuation is only systematic risk; corporate risk management may only reduce the total risk. ¬†Relevant to maximizing the firms value.

Problem 1: Cray Research sold a supercomputer to the Max Planck Institute in Germany on credit and invoiced 10 million euros payable in six months. Currently, the six month forward exchange rate is $1.10/euro and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/Euro in six months

What is the expected gain/loss from a forward hedge?

Gain=(f-S)* 10 million euros

Gain=(1.10$/Euro-1.05$/euro) * 10 million euros= $500,000

If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? why or why not?

I would recommend hedging  the euro receivable. With the hedge Cray Research would receive (1.1$/euro*10 million Euro)= $11,000,000 in six months opposed to (1.05$/euro*10 million Euro)= $10,500,000 in six months at the predicted spot rate. This way the Cray Research not only gains $500,000 but also eliminates exchange exposure.

Suppose the foreign exchange adviser predicts that the future spot rate will be the same as the forward exchange rate quoted today. would you recommend hedging in this case? Why or why not?

I would recommend hedging because if the predicted future spot rate is the same  as the forward exchange rate quoted today, the gains or losses would be approximately $0 and an averse to risk firm can eliminate exchange rate exposure.

Problem 2

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed 250 million yen payable in three months. 

Current spot rate:   $1=105 Yen

3-month forward rate: $1=100 Yen

U.S. interest rate:  8% per year

Japan interest rate:  7% per year

The management of IBM decided to use a money market hedge to deal with this yen account payable.

1. Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

A money market hedge involves investing an amount in domestic and foreign money markets today that, in the future, will adequately satisfy the payable as it becomes due.

In this case IBM will invest the PV of the payable at the Japanese interest rate of 7% per year and will then have the 250 million yen it needs to pay the payable in three months. To do this, IBM will have to put forth a certain dollar amount today to buy the yen at the current spot rate.

Step 1:  Compute the present value of the foreign currency payable.

FV= 250,000,000 Yen

Rate= 1.75% (7%/4 to get to quarterly rate)

Periods= 1 three-month period

PV= 245,700,246 Yen

Step 2: Compute the dollar amount needed today to invest.

Current spot rate: $1=105 Yen

1 Yen=$0.0095

245,700,246 Yen is equivalent to $2,340,002 today.

The dollar cost of meeting the yen obligation is the future value of the today’s dollar cost.

$2,340,002 x (1.02)=$2,386,802.39

(8%/4 to get quarterly rate)

1. Cash flow analysis

CF today CF at maturity
Dollars needed to invest in Japan 2340002
Buy Yen with dollars 245700246
Invest Yen -245700246 250000000
Pay liability -250000000
Net cash flow 0

Chapter 9  Management of Economic Exposure Problems (Q4, Q7, Q8, Q9, Problem 1A)

Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.  Operating exposure cannot be determined from accounting statements as transaction exposure.

Q4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.

Competitive effect: how depreciation/appreciation affects operating cash flow by altering the firms competitive position in the marketplace.  This depends on the market structure of inputs and products: how competitive or monopolistic the markets facing the firm are.  Conversion effect: how depreciation/appreciation changes the operating cash flow by the firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

Example: Due to the hyperinflation crisis in Zymbabwe, there was an extreme depreciation in the value of the Zymbabwe dollar.  Zymbabwe’s rate of inflation reached 79.6 Billion %! In effect, Zymbabwe grain, like many other Zymbabwe imports suffered significantly.  So, the exposure to grain companies had two components:

1. Competitive effect: difficulties and a increased costs for importing and selling grain

2. Conversion effect: lower dollar prices of imports due to foreign currency  exchange rate depreciation

8) What are the advantages and disadvantages to a firm of financial hedging of its operating exposure compared to operational hedges (such as relocating its manufacturing site)

Operational hedges

a. Selecting low-cost production sites

РSetting up in an area with relatively weak currency.  Giving you cheaper labor and production costs

b. Flexible sourcing policy

– Choosing to source operations from countries where input costs are low.

c. Diversification of the market

РEconomies all around the world change all the time.  If you place your entire product line in one country, a lull in the economy can lead to huge decreases in the demand for your product.  This is much more unlikely if you place your product all around the world.

d. R&D efforts and product differentiation

– Positive R&D efforts can cut costs and lead to new, innovative product ideas

These options are certainly valuable and are frequently utilized by firms all around the world.  However, many times these options (which involve redeployment of resources) can become costly and impractical.  This is when financial hedging is a much better option.

Financial hedging

This is used to stabilize the firm’s cash flows by investing in currency forwards or options (also by lending and borrowing). ¬†This will eliminate a large portion of the exchange rate risk. ¬†However, since investing in these derivatives only takes in account the nominal value and not the real value (which is what you are interested in), financial hedging can only provide an approximate hedge against the firms operating exposure.

Q9: Discuss the advantages and disadvantages of maintaining multiple

manufacturing sites as a hedge against exchange rate exposure.


1. Business stability from less exposure to exchange rate volatility.

2. Production flexibility to maximize low-cost benefits of currency depreciation.

3. Global presence, which may catalyze market diversification (another hedge).


1. Increased risk (political, social etc.)

2. Increased production costs (inability to realize economies of scale). Unable to predict currency fluctuations long-term (currencies moving in unintended manner)


1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

Solution: (a)

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

Exposure netting-hedging based on net exposure, no one hedges gross exposure

Exposure on assets and operating cash flow

Operating exposure having impact on operating cash flow based on exchange rates impacted on net income level

Determinants of operating exposure

Managing operating exposure-r and d, 5 items

Financial hedging is listed as something to be done for economic exposure, short-term in nature and is note effective as other items

Statistical perspective

Euro and foreign bonds characteristics-don’t need to know tax rules

Euro medium notes

Currency Distribution, nationality and blah skip

International bond ratings



Clearing procedures-skip

International Bond Market Index

Market Capitalization in developing countries vs.  others

Concentration very liquid and very diversified in mature, less concentrated and liquid in developing

Market structure, cost, and trading practices

Market Consolidation

Trading in International Equities

Yankee stock offerings

American Depository Receipts

International equity benchmarks


Factors affecting international equity