Transaction exposure definition and difference 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.
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 “optional” 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.
Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. Explain result. In a “perfect” 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 an only systematic risk; corporate risk management may only reduce the total risk. Relevant to maximizing the firms’ value.
SOLD 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= $500,000
I would recommend hedging the euro receivable. With the hedge Cray Research would receive (1.1$/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 adverse to risk firm can eliminate exchange rate exposure.
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. 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: 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
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|
|Net cash flow||0|