Topic 6 Transaction and Translation Exposure

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Transaction Exposure
How would you define transaction exposure? How is it different from economic
Discuss and compare hedging transaction exposure using the forward contract vs.
money market instruments. When do the alternative hedging approaches produce the
same result?
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.
Should a firm hedge? Why or why not?
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?
(b) If you were the financial manager of Cray Research, would you recommend hedging
this € receivable? Why or why not?
(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?
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 three-month call option on
SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that
International Financial Management
your expected future spot exchange rate is the same as the forward rate. The threemonth
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.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge
using a forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and
option market hedges?
(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.
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 oneyear
forward rate is $1.10/€. The annual interest rate is 6.0 percent in the U.S. and 5.0
percent in France. Boeing is concerned with the volatile exchange rate between the
dollar and the euro and would like to hedge its exchange exposure.
(a) It is considering two hedging alternatives: sell the euros proceeds from the sale forward
or borrow euros from Credit Lyonnais against the euro receivable. Which alternative
would you recommend? Why?
(b) Others things being equal, at what forward exchange rate would Boeing be indifferent
between the two hedging methods?
The Melbourne Tile Company has received an order from a Korean manufacturing
company for machinery worth Won 1,120,000,000. The export sale would be
denominated in Korean won. The Melbourne Tile Company’s opportunity cost of funds
is 14%. The current spot rate is Won 800/$, 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. Past Exam Question
(i) If the Melbourne Tile Company does not hedge and assuming that your finance staff is
correct in their forecasts, what will be its dollar proceeds today?
International Financial Management
(ii) If the Melbourne Tile Company hedges in the money market, what will be its dollar
proceeds 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
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 Dell’s Asian profits of a strengthened dollar? Explain.
(b) What hedging technique(s) can Dell employ to lock in a desired currency conversion
rate for its Asian sales during the next year?
(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?
(d) What are the limits of Dell’s hedging approach?
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?
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?
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.
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? Past Exam Question
International Financial Management
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. 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. Past Exam Question
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?
(b) Was he wise to accept the bids in each bidding company’s own currency? Please
explain briefly.
Samuel Samosir works for Peregrine Investments in Jakarta, Indonesia. He focuses his
time and attention on the U.S. dollar/Singapore dollar ($/S$) 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:
Past Exam Question
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?
(b) Using your answer to (a), what is Samuel’s break-even price?
International Financial Management
(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 $0.7000/S$?
Translation Exposure
Explain the difference in the translation process between the monetary/non-monetary
method and the temporal method.
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/non-current
method, the monetary/non-monetary method, and the temporal method?
How does translation (or accounting) exposure differ from economic exposure?
Past Exam Question
What factors affect a company’s translation exposure? What can the company do to
affect its degree of translation exposure?
What is the basic translation hedging strategy? How does it work?
Paragon U.S.’s 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/$.
(a) What is Paragon Japan’s net translation exposure at the beginning of the year in yen? In
(b) What is Paragon Japan’s translation gain or loss from the change in the yen’s value?
(c) At the start of the next year, Paragon Japan adds exposed assets of ¥1.5 billion and
exposed liabilities of ¥2 billion. During the year, the yen depreciates from ¥95/$ to
¥130/$. What is Paragon Japan’s translation gain or loss for this year? What is its total
translation gain or loss for the two years?

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