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 firm’s 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.
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 payables 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. How would you explain this 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 riskRelevant to maximizing the firm’s 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 adverse 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.
- 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 today’s dollar cost.
$2,340,002 x (1.02)=$2,386,802.39
(8%/4 to get quarterly rate)
- Cash flow analysis
| CF today | CF at maturity | |
| Dollars needed to invest in Japan | 2340002 | |
| Buy Yen with dollars | 245700246 | |
| -2340002 | ||
| Invest Yen | -245700246 | 250000000 |
| Pay liability | -250000000 | |
| Net cash flow | 0 |
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.
Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.
1. Competitive effect: how depreciation/appreciation affect 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.
2. 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 Zimbabwe, there was an extreme depreciation in the value of the Zimbabwe dollar. Zimbabwe’s rate of inflation reached 79.6 Billion %! In effect, Zimbabwe grain, like many other Zimbabwe imports suffered significantly. So, exposure to grain companies had two components:
1. Competitive effect: difficulties and 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 of 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
– Setting up in an area with a 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
– Economies 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 into 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. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure. Advantages include Business stability from less exposure to exchange rate volatility, Production flexibility to maximize low-cost benefits of currency depreciation, Global presence, which may catalyze market diversification (another hedge). Disadvantages: 1. Increased risk (political, social, etc.), and Increased production costs (inability to realize economies of scale). Unable to predict currency fluctuations long-term (currencies moving in an unintended manner).
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 pounds will be worth $1.40. If the British economy slows down, on the other hand, the land will be worthless, 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 = $1.44
Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2
= .00096+.00144 = .0024.
Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)
= -5.28-7.92 = -13.20
b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.
Canada dollar in US$ per $1-mos forward 1.0040 0.99603-mos forward. 0027 0.99736-mos forward 1.0003 0.9997Swiss Franc in US$ per $1-mos forward 1.0600 0.94313-mos forward 1.0609 0.94266-mos forward 1.0619 0.9417Data from The Wallstreet Journal Jan 26, 2011Swiss Franc in Canada $ per Canada $1-mos forward 1.0561 0.94693-mos forward 1.0580 0.94526-mos forward 1.0616 0.94206. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Canadian dollar versus the U.S. dollar using American term quotations. For simplicity, assume each month has 30 days. What is the interpretation of your results? The forward premium or discount for the Canadian dollar versus the U.S dollar using American term quotations.Spot Rate .99841-month .99863-month .99886-month .9979This shows that the Canadian dollar is selling at a premium to the dollar. The premium is increasing out to the 3-month mark. The U.S. dollar will depreciate compared to the Canadian dollar for 3 months and then appreciate compared to the Canadian dollar at month 6.1-month forward premium=(.9986-.9984)/.9984*(360/30)=.240%3-month forward premium=(.9988-.9984)/.9984*(360/60)=.240%6 month forward premium=(.9979-.9984)/.9984*(360/180)=-.100%9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate. Certain banks specialize in making a direct market between nondollar currencies, pricing at a narrower bid-ask spread than the cross rate-spread. If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible.10. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes: Swiss franc/dollar = SFr 1.5971/$Australian dollar/U.S. dollar = A$ 1.8215/$Australian dollar/Swiss franc = A$ 1.1440/SFrIgnoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes? If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how much would he profit if he has $1,000,000 available for this purpose? Ignoring transaction costs, Doug has an arbitrage opportunity of $3,064.73 trading with $1,000,000. He would trade from US dollar to Swiss franc, from Swiss franc to Australian dollar, and then from Australian dollar to US dollar$ 1,000,000x 1.5971SFr 1,597,100 Sell US dollars for Swiss francs 1.1440A$ 1,827,082.4 Sell Swiss francs for Australian dollars/ 1.8215$ 1,003,064.73 Sell Australian dollars for US dollars- 1,000,000.00$ 3,064.73 Arbitrage Profit12. The current spot exchange rate is $1.95/pound and the three-month forward rate is $1.90/pound. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/pound in three months. Assume that you would like to buy or sell 1,000,000 pounds.A. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?- If you believe the spot exchange rate will be $1.92/pound in three months, you should short the three-month $/pound contract. By doing, you can buy for $1.92/pound and then deliver it for $1.90/pound. This means you’ve made a profit of .02 per unit. The total profit is then $20,000.B. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/pound?- If the spot exchange rate actually turns out to be $1.86/pound, you’ve lost money. This means you are forced to buy at $1.86/pound and then sell it at $1.90/pound. This means you would lose $40,000.Group 6 Chapter 8 problems William Atherton; Haroon Tekrawala; Bradley Wong; Nicole Decraene; Wesley REECE Sanford; Ethan Garber; Jenna Brock;