Topic 6 Foreign Exchange Exposure – Solutions

FIND A SOLUTION AT Academic Writers Bay

Transaction Exposure
How would you define transaction exposure? How is it different from economic
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.
Discuss and compare hedging transaction exposure using the forward contract
vs. 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.
Suppose your company has purchased a put option on the German mark to
manage 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.
International Financial Management
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.
Cray Research sold a super computer to the Max Planck Institute in Germany on
credit 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 recommend
hedging 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 be
the 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.
You plan to visit Geneva, Switzerland in three months to attend an international
business 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 threemonth
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 hedge
via call option on SF.
International Financial Management
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 the
exercise 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
(=0.63×5,000). 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 to
hedge using a forward contract.
$3,150 = (0.63) (5,000).
(c) At what future spot exchange rate will you be indifferent between the forward
and 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.
Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air
France 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) =
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 $800,000 more by using Forward hedge.
International Financial Management
(b) Others things being equal, at what forward exchange rate would Boeing be
indifferent between the two hedging methods?
According to IRP, F = S (1+i$)/(1+i€). Thus the “indifferent” forward rate will be: F =
(1.05) (1.06)/(1.05) = $1.06/€.
The Melbourne Tile Company has received an order from a Korean manufacturing
company for machinery worth Won 1,120,000,000. The export sale would be
denominated in Korean won. The Melbourne Tile Company’s opportunity cost of
funds is 14%. The current spot rate is Won 800/$, 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 finance
staff are correct in their forecasts, what will be its dollar proceeds today?
(Won800/$)/0.92=Won 869.57
or [1 ÷ Won800/$] = $0.00125/Won * (0.92) = $0.00115/Won
(updated by Kelvin Tan on 13 June 2013)  [1 ÷ $0.00115/Won] = Won 869.5652/$
Won1,120,000,000/((Won869.5652/$) = $1,288,000
PV=$1,288,000/ (1.14) = $1,129,824.58
(ii) If the Melbourne Tile Company hedges in the money market, what will be its
dollar proceeds today?
Borrow PV of Won1,120,000,000 in Seoul today @ 10%:
Won1,120,000,000/1.10 = Won1,018,182,000
Exchange 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 today?
The premium‐cost for options, paid today, is:
Won1,120,000,000×0.0125/(Won800/$) = $17,500
When we exercise the options, we sell the Won @Won800/$:
Won1,120,000,000/(Won800/$) = $1,400,000 at the end of the year
Present value of those proceeds, at a 14% U.S. cost of capital:
$1,400,000/1.14 = $1,228,070
Net of the premium costs, the U.S. dollar proceeds are:
International Financial Management
$1,228,070 ‐ $17,500 =$1,210,570
Dell Computer, an American firm, produces its machines in Asia with
components largely imported from the United States and sells its products in
various Asian nations in local currencies.
(a) What is the likely impact on Dellʹs Asian profits of a strengthened dollar?
Dellʹs dollar costs largely stay fixed whereas its dollar revenues will decline. Thus, a
strengthened dollar reduced Dellʹs dollar profits on its Asian sales.
(b) What hedging technique(s) can Dell employ to lock in a desired currency
conversion rate for its Asian sales during the next year?
Dell can use forward or futures contracts to sell the Asian 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 to
foreclose 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 Dellʹs 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 yearʹs revenues, it
will pay a price for these contracts that reflect the devalued exchange rates of the
local Asian currencies.
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
International Financial Management
on the salaries these players would earn in the United States; they are not
based on Canadian salaries.
In order to eliminate all risk on its exports to Japan, a company decides to hedge
both 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.
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.
In your role as an advisor to the CFO of Watermelon Technologies you have
been asked to write a report on why hedging might reduce agency costs. While
you have no problems convincing him that bondholders would prefer the firm
hedge exchange rate risk, what arguments would you put forward to persuade
him that he has a personal stake in the decision as well?
Hedging reduces AGENCY COSTS. Here you need to focus on the conflict of
interest between shareholders and the managers of the firm. The wages and bonus
plan 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 he
Beach Comber, the mayor of Sandy Beach in Australia, has received bids from
three 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.
International Financial Management
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 rate
corresponds to the expected completion data of each stage.
Company stage 1 stage 2 stage 3
London 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$ 1,500,000
Forward 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 0
London Dredging 1 (1,700,000/1.65) /1.06 = 971,984
2 (1,800,000/1.70) /1.0625 = 996,540
3 (1,900,000/1.75) /1.065 = 1,019,450
Total time‐0 value of the bid 2,987,974
Marseille Dredging 1 (5,200,000/5.5) /1.06 = 891,938
2 (5,800,000/5.45) /1.0625 = 1,001,619
3 (6,500,000/5.35) /1.065 = 1,140,801
Total time‐0 value of the bid 3,034,358
Vancouver Dredging 1 (1,300,000/1.35) /1.06 = 908,456
2 (1,400,000/1.3) /1.0625 = 1,013,575
3 (1,500,000/1.25) /1.065 = 1,216,761
Total time‐0 value of the bid 3,048,791
Mayor 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$, each bidder would have to use an expensive hedge or
bear substantial risk during the bidding process. This would likely cause them to
increase their bids.
Samuel Samosir works for Peregrine Investments in Jakarta, Indonesia. He
focuses his time and attention on the U.S. dollar/Singapore dollar ($/S$)
International Financial Management
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 the
coming 90 days, probably to about $0.7000/S$. He has the following options on
the Singapore dollar to choose from:
Option Strike Price Premium
Put 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 =
(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
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 Exposure
Explain the difference in the translation process between the monetary/nonmonetary
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.
How are translation gains and losses handled differently according to the current
rate method in comparison to the other three methods, that is, the current/noncurrent
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
International Financial Management
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.
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
 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.
What factors affect a companyʹs translation exposure? What can the company do
to affect its degree of translation exposure?
The factors affecting a companyʹs translation exposure include the currency of the
primary economic environment in which the company (or its affiliate) does
business, the currency in which it invoices its sales, the currency in which it
negotiates to buy, the currency denomination of its borrowings, the currency
denomination of the securities in which it invests surplus cash, and the location of
its 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 purchases
in the local currency. It also has some degree of control over which customers to
serve ‐‐ foreign or domestic ‐‐ but this decision should be based on economic
profitability rather than its impact on translation exposure.
What is the basic translation hedging strategy? How does it work?
The basic translation hedging strategy involves increasing hard‐currency assets and
decreasing soft‐currency assets, while simultaneously decreasing hard‐currency
liabilities and increasing soft‐currency liabilities. The specific techniques used to
hedge a particular translation exposure all involve establishing an offsetting
currency 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.
International Financial Management
Paragon U.S.ʹs Japanese subsidiary, Paragon Japan, has exposed assets of ¥8
billion and exposed liabilities of ¥6 billion. During the year, the yen appreciates
from ¥125/$ to ¥95/$.
a. What is Paragon Japanʹs net translation exposure at the beginning of the year in
yen? 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
b. What is Paragon Japanʹs translation gain or loss from the change in the yenʹs
At the end‐of‐year exchange rate, Paragon Japanʹs 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 ‐ $16,000,000).
c. At the start of the next year, Paragon Japan adds exposed assets of ¥1.5 billion
and exposed liabilities of ¥2 billion. During the year, the yen depreciates from
¥95/$ to ¥130/$. What is Paragon Japanʹs translation gain or loss for this year?
What is its total translation gain or loss for the two years?
Paragon Japanʹs 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).
When should we be finding the Future value or Present value of the proceeds?
In some textbook questions, they don’t specify whether they want the present value
or future value of the proceeds. In the exam, I will be very clear on what is required
of you.

YOU MAY ALSO READ ...  Develop your group’s understanding of cyber security
Order from Academic Writers Bay
Best Custom Essay Writing Services