# Lecture 5: Exchange Rate Exposure

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Transaction Exposure Example
• Transaction exposure arises because of the risk that the Australian seller
will receive something other than \$1,620,000 when the buyer pays them in
60 days.
• If the euro weakens to \$0.8500/€, then Trident will receive
\$1,530,000 (€1.8mil * \$0.85/€)
• If the euro strengthens to \$0.9600/€, then Trident will receive
\$1,728,000 (€1.8mil * \$0.96/€)
• Thus, exposure is the chance of either a loss or a gain.
FINM7406 1/04/2020 CRICOS code 00025B 4
Value-at-Risk
• With the normal distribution, the 5% tail probability of adverse move starts at
1.65 standard deviation below the mean.
x = μ – 1.65 * σ
• So, x= 0 – 1.65 * 0.06 = – 0.099
• For the \$12m position,
• VaR = -0.099 * \$12m =–\$1,188,000
[i.e. there is 5% chance of losing \$1,188,000] over the next month.
• Problems with VaR?
FINM7406
1/04/2020 CRICOS code 00025B 5
Boeing’s Forward Hedge
• In a year’s time, Boeing will receive the £10m and convert to USD14.6m
• What would Boeing’s gain or loss from hedging be if at the end of one year
ST=1.60?
• If Boeing had not hedged, they could have received
USD 16m
• Gain/Loss from forward hedging: (F – ST) * FC hedged
= (1.46-1.6)10million = -1.4million FINM7406 1/04/2020 CRICOS code 00025B 6 In class question DKNY, a US company, owes €70 million in 30 days for a recent shipment of Spanish textiles. It faces the following interest and exchange rates:  Spot rate: € 130/\$  Forward rate (30 days) € 131/\$  30-day put option on dollars at € 129/\$  1% premium  30-day call option on dollars at € 131/\$  3% premium  U.S. dollar 30-day interest rate (annualized): 7.5%  € 30-day interest rate (annualized): 15% FINM7406 1/04/2020 CRICOS code 00025B 7 In class question 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 € forward, DKNY can lock in a dollar cost of 70,000,000/131 = \$534,351 FINM7406 1/04/2020 CRICOS code 00025B 8 In class question b) What is the hedged cost of DKNY’s payable using a money market hedge? • What do they want to do? Receive EUR so they can pay the payable • So need to invest in EUR • Borrow in USD • How much? Borrow PV of the € 70 million payable, which equals € 69,135,802 (70,000,000/1.0125), convert to USD at spot rate of € 130/\$ =69,135,802/130 = 531,814 FINM7406 1/04/2020 CRICOS code 00025B 9 In class question CF0 CF1 Borrow USD 531,814 x 1.00625 USD 531814 -535138 Convert to EUR USD -531814 531814/130 EUR 69135802 Invest in EUR EUR -69135802 70000000 Pay EUR payable EUR -70000000 Net CFs USD 0 -535138 FINM7406 1/04/2020 CRICOS code 00025B 10 In class question c) What is the hedged cost of DKNY’s payable using an option? (ignore time value of money) • Company needs buy EUR to pay the payable. • Options quoted terms of USD, this means they want to sell USD and receive EUR • Need a put option on the USD • Premium = 1% of USD amount • USD amount = 70,000,000/130 = 538,461.54 • Premium = 1%538,461.54 = \$5,385
• If they exercise the option = 70m/129 = 542,636
• Total payable = 5,385+ 542,636 = \$548,021
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In class question
• Although it looks as if the put option costs \$13,670 more than the forward
contract, these costs are not strictly comparable.
• The put option gives DKNY the option to buy € in the spot market in 30
days if the spot rate of the dollar at that time exceeds the exercise price of €
129/\$. Hence, the option cost is the maximum cost of using a put option.
• On the other hand, with a forward contract, DKNY must buy € at € 131/\$
even if the spot rate at time of settlement is lower at, say, € 133/\$.
• The value of this option accounts for the 1% premium that DKNY must pay
to acquire the put option.
FINM7406

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