Chapter 8
Problem 8.3 Hindustan LeverAdvise Hindustan Lever on its Japanese yen purchase.
Assumptions / Values
180-day account payable, Japanese yen (¥) / 8,500,000
Spot rate (¥/$) / 120.60
Spot rate, rupees/dollar (Rs/$) / 47.75
Implied (calculated) spot rate (¥/Rs) / 2.5257 / (120.60/47.75)
180-day forward rate (¥/Rs) / 2.4000
Expected spot rate in 180 days (¥/Rs) / 2.6000
180-day Indian rupee investing rate / 8.000%
180-day Japanese yen investing rate / 1.500%
Currency agent’s exchange rate fee / 4.850%
Hindustan Lever’s cost of capital / 12.00%
Spot / Risk
Hedging Alternatives / Values / Rate (Rp/$) / Assessment
1. Remain Uncovered, settling A/P in 180 days at spot rate
If spot rate in 180 days is same as current spot / 3,365,464.34 / 2.5257 / Risky
If spot rate in 180 days is same as forward rate / 3,541,666.67 / 2.4000 / Risky
If spot rate in 180 days is expected spot rate / 3,269,230.77 / 2.6000 / Risky
2. Buy Japanese yen forward 180 days
Settlement amount at forward rate (Rs) / 3,541,666.67 / 2.4000 / Certain
(Continued)
Problem 8.3 Hindustan Lever (Continued)
3. Money Market Hedge
Principal A/P (¥) / 8,500,000.00
discount factor for yen investing rate for 180 days / 0.9926
Principal needed to meet A/P in 180 days (¥) / 8,436,724.57
Current spot rate (¥/Rs) / 2.5257
Indian rupee, current amount (Rs) / 3,340,411.26
Hindustan Lever’s WACC carry-forwad factor for 180 days / 1.0600
Future value of money market hedge (Rs) / 3,540,835.94 / Certain
4. Indian Currency Agent Hedge
Principal A/P (¥) / 8,500,000.00
Current spot rate (¥/Rs) / 2.5257
Current A/P (Rs) / 3,365,464.34
Plus agent’s fee (4.850%) / 163,225.02
Hindustan’s WACC carry-forwad factor for 180 days on fee / 1.0600
Total future value of agent’s fee (Rs) / 173,018.52
Total A/P, future value, A/P fee (Rs) / 3,538,482.87 / Certain
Evaluation of Alternatives
The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.
Problem 8.4 Mattel Toys
Advise Mattel on its European sales.
Assumptions / Values
90-day A/R (€) / €30,000,000.00
Current spot rate (4/€) / $1.2186
Credit Suisse 90-day forward rate ($/€) / $1.2170
Barclays 90-day forward rate ($/€) / $1.2210
Expected spot rate in 90 days ($/€) / $1.1800
90-day eurodollar interest rate / 4.000%
90-day euro-euro interest rate / 4.400%
Implied 90-day forward rate (calculated, $/€) / $1.2174
90-day eurodollar borrowing rate / 5.600%
90-day euro-euro borrowing rate / 6.400%
Mattel Toys weighted average cost of capital ($) / 9.600%
Risk
Hedging Alternatives / Values / Assessment
1. Remain Uncovered, settling A/R in 90 days at market rate
(20 million euros/future spot rate)
If spot rate in 90 days is same as current / $36,558,000.00 / Risky
If spot rate in 90 days is same as Credit Suisse forward rate / $36,510,000.00 / Risky
If spot rate in 90 days is same as Barclays forward rate / $36,630,000.00 / Risky
If spot rate in 90 days is expected spot rate / $35,400,000.00 / Risky
2. Sell euros forward 90 days
Settlement amount at Credit Suisse forward rate / $36,510,000.00 / Certain
Settlement amount at Barclays forward rate / $36,630,000.00 / Certain
3. Money Market Hedge
Principal A/R in euros / €30,000,000.00
discount factor for euro borrowing rate for 90 days / 0.9843 / 1/(1 (0.064 90/360))
Borrow euros against 90-day A/R / €29,527,559.06
Current spot rate, $/euro / $1.2186
US dollar current value / $35,982,283.46
Mattel’s WACC carry-forward factor for 90 days / 1.0240 / 1 (0.0960 90/360)
Future value of money market hedge / $36,845,858.27 / Certain
Evaluation of Alternatives
The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).
Problem 8.5 Tek: Italian account receivable
Hedging foreign exchange risk: a receivable
Assumptions / Values
Account receivable due in 3 months, in euros (€) / €4,000,000.00
Spot rate ($/(€) / 1.2000
3-month forward rate ($/€) / 1.2180
3-month euro interest rate / 4.200%
3-month put option on euros:
Strike rate ($/€) / 1.0800
Premium, percent per year / 3.400%
Tek’s weighted average cost of capital / 9.800%
a) / b)
What are the costs and risk of each alternative? / Value / Certainty?
1. Do nothing and exchange euros for dollars at end of 3 months
Amount of euro receivable / €4,000,000.00
If spot rate in 3 months is the same as the forward rate / 1.2180 / Very uncertain;
US dollar proceeds of receivable would be / $4,872,000.00 / Risky
Amount of euro receivable / €4,000,000.00
If spot rate in 3 months is the same as the current spot rate / 1.2000 / Very uncertain;
US dollar proceeds of receivable would be / $4,800,000.00 / Risky
2. Sell euro receivable forward at the 3-month forward rate
Amount of euro receivable / €4,000,000.00
forward rate / 1.2180 / Certain;
US dollar proceeds of receivable would be / $4,872,000.00 / Locked-in
Problem 8.5 Tek: Italian account receivable (Continued)
3. Buy a put option on euros
Amount of euro receivable / €4,000,000.00
Current spot rate ($/euro) / 1.2000
Premium on put option, % / 3.400%
Cost of put option (amount spot rate percent premium) / $163,200.00
If the spot rate at end of 3-months is less than strike rate / Minimum is
the option is exercised yielding gross dollars of / $4,320,000.00 / guaranteed;
Less cost of option (premium) plus US$interest on premium / $(167,198.40) / could be
Net proceeds of A/R if option is exercised (this is Minimum) / $4,152,801.60 / greater.
Summary of Alternatives / Value / Certainty?
Do Nothing / $4,800,000.00 / Risky
Sell A/R forward / $4,872,000.00 / Certain
Buy Put Option / $4,152,801.60 / Minimum
c) If Tek wishes to play it safe, it should lock in the forward rate.
d) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3-month period,
past $1.20/€, then Tek might consider purchasing the put option on euros.
Problem 8.6 Tek: Japanese account payable
Hedging foreign exchange risk: a payable
Assumptions / Values
Account payable to Japan Sony-Tek, in Japanese yen (¥) / 8,000,000.00
Spot rate (¥/$) / 108.20
6-month forward rate (¥/$) / 106.20
6-month yen deposit rate / 1.250%
6-month dollar interest rate / 4.000%
6-month call option on yen:
Strike rate (¥/$) / 108.00
Premium, percent per year / 2.500%
Tek’s weighted average cost of capital / 9.800%
What are the costs and risk of each alternative? / a) Value / b) Certainty
1. Do nothing and exchange dollars for yen at end of 6 months
Amount of yen payable / 8,000,000.00
If spot rate in 3 months is the same as the forward rate / 106.20 / Very uncertain;
US dollar cost of settling payable would be / $75,329.57 / Risky
Amount of yen payable / 8,000,000.00
If spot rate in 3 months is the same as the current spot rate / 108.20 / Very uncertain;
US dollar cost of settling payable would be / $73,937.15 / Risky
2. Buy yen forward 6-months to lock in cost of settling payable
Amount of yen payable / 8,000,000.00
forward rate / 106.20 / Certain;
US dollar cost of settling payable would be / $75,329.57 / Locked-in
Problem 8.6 Tek: Japanese account payable (Continued)
3. Money market hedge—invest funds in yen deposit now
Principal needed at the end of 6-months, yen / 8,000,000
Discount factor, 6-months @ yen deposit rate / 0.9938 / 1/(1 (0.0125 180/360))
Yen deposit needed, now / 7,950,311
Current spot rate (¥/$) / 108.20
US dollars needed now, for exchange into yen / $73,477.92
Carry-forward rate, 6 months @ Tek’s WACC / 1.05 / 1 (0.0980 180/360)
US cost of money market hedge at end of 6-months / $77,078.33
4. Buy a call option on Japanese yen
Amount of yen payable / 8,000,000.00
Current spot rate (¥/$) / 108.20
Premium on call option, % / 2.500%
Cost of call option / $1,848.43
If the spot rate at end of 3-months is greater than strike rate / Maximum cost
the option is exercised yielding gross dollars of / $74,074.07 / guaranteed;
Plus cost of option (premium) plus US$interest on premium / $1,939.00 / could be
Total cost of exercising call option on yen / $76,013.08 / less.
Summary of Alternatives: Cost of settling A/P / Value / Certainty?
Do Nothing / $73,937.15 / Risky
Buy yen forward / $75,329.57 / Certain
Deposit yen now (money market hedge) / $77,078.33 / Certain
Buy call option on yen / $76,013.08 / Maximum
c) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere below the option strike rate of ¥108/$, then Tek might consider purchasing the call option. If Tek is a bit more risk adverse, the forward rate is relatively attractive compared to the money market hedge.
Problem 8.7 Tek: British Telecom bidding
Hedging foreign exchange risk of a contract bid
Assumptions / Values
Account receivable of bid, supply & install (British pounds, £) / £1,500,000
Spot rate ($/£) / 1.8418
Tek’s weighted average cost of capital / 9.800%
1-month / 4-month
Forward rate ($/£) / 1.8368 / 1.8268
British pound investment rate / 4.000% / 4.125%
British pound borrowing rate / 6.500% / 6.500%
Put option on pound:
Strike rate ($/£) / 1.85 / 1.85
Premium ($/£) / $0.006 / $0.012
Analysis and Evaluation / a) Value / b) Certainty
If Tek wins the bid, it will be long foreign currency, having a 1.5 million
pound position which is first backlog then an A/R.
If and when Tek is awarded the bid, it would have 4 months (120 days)
until cash settlement of the 1 million pound position.
1. Do Nothing—Remaining Uncovered
Wait 120 days and exchange pounds for dollars spot
If the ending spot rate is the same as current spot rate / $2,762,700.00 / Risky
If the ending spot rate is the same as the 4-month forward rate / $2,740,200.00 / Risky
It could, however, be much lower.
2. Sell the pounds forward
Selling 1 million pounds forward at the 4-month forward rate / $2,740,200.00 / Certain Value
The primary problem with this is that if Tek does not win the bid, / If Tek Wins Bid
it has a forward contract to sell pounds which it will not earn.
3. Money market hedge—borrow against expected receipts
Expected receipts (£) / £1,500,000
Discount factor for 4-months at pound borrowing rate / 0.9788 / 1/(1(0.065 120/360))
Proceeds from borrowing, now (£) / £1,468,189
Current spot rate ($/£) / 1.8418
Proceeds from borrowing, now ($) / $2,704,110.93
Carry-forward rate, 4 months @ Tek’s WACC / 1.0327 / 1 (0.098 120/360)
Value in 4 months of money market hedge ($) / $2,792,445.22
4. Buy a put option on pounds at strike price of 1.85
Option, if exercised (if ending spot rate less than $1.85) / $2,775,000.00
Put option premium, up-front / $18,000.00
and the 4-months opportunity cost of premium / 588.00
Total premium expense / $18,588.00
Minimum;
Minimum dollars received if put option purchased / $2,756,412.00 / Could be More
The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid’s award. The advantage of the option is if Tek does not win the bid, the option can easily be sold.
Problem 8.8 Tek—Swedish price list
Hedging foreign currency price quotes and potential sales.
Assumptions / Values
Expected sale over 90-day period, Swedish krona (SKr) / 5,000,000.00 / Could be more
Spot rate (SKr/$) / 7.4793
90-day forward rate (SKr/$) / 7.4937
3-month dollar interest rate / 4.000%
3-month krona deposit interest rate / 4.780%
3-month krona borrowing interest rate / 6.500%
3-month put option on krona:
Strike rate (SKr/$) / 7.50
Premium / 2.500%
Tek’s weighted average cost of capital / 9.800%
Hedging Alternatives
This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of
sales will occur, and therefore what Tek’s actual long position in Swedish krona will be.
Value / Certainty?
1. Do Nothing—Remain Uncovered.
The ending spot rate at the time of settlement
could be nearly anything.
If the ending spot rate is the same as current spot rate (SKr/$) / $668,511.76 / Risky
If the ending spot rate is the same as forward (SKr/$) / $667,227.14 / Risky
2. Sell Swedish krona forward
Sold forward 3-months at forward rate (SKr/$) / $667,227.14 / Certain
However, remember that Tek does not know total sales.
Problem 8.8 Tek—Swedish price list (Continued)
3. Money market hedge
Tek would borrow now against expected proceeds of (SKr) / 5,000,000.00
Discount rate of SKr interest rate for 90-days / 0.98401
SKr proceeds from borrowing received up-front / 4,920,049.20
Exchanged at current spot rate (SKr/$) / 7.48
US dollars received now / $657,822.15
Tek carry-forward rate for US$for 90 days / 1.025
Money market hedge proceeds in 90-days / $673,938.79
4. Buy a 3-month put option on Swedish krona / If exercised / If not exercised
Proceeds will be option less premium if exercised (minimum) / (random choice)
Exchange rate if exercised/not exercised (SKr/$) / 7.50 / 7.24
Amount of Swedish krona / 5,000,000.00 / 5,000,000.00
If exercised, it will yield a gross dollar amount of / $666,666.67 / $690,607.73
Put option premium / $16,712.79 / $16,712.79
Opportunity cost of premium / 409.46 / 409.46
Total future value of premium / $17,122.26 / $17,122.26
Minimum net dollar proceeds at end of 90 days / $649,544.41 / $673,485.48
(exercised gross amount less future value of premium) / Minimum
The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in relative value arising from carrying-forward the dollars at Tek’s WACC.)
If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the same amount of US dollars as the money market hedge.
Problem 8.9 Tek: Swiss dividend payable
Hedging an intra-company dividend payment.
Assumptions / Values
Dividend declared, Swiss francs (SFr) / SFr. 5,000,000
Spot rate (SFr/$) / 1.2462
90-day forward rate (SFr/$) / 1.2429
3-month US dollar interest rate / 4.000%
3-month Swiss franc interest rate / 3.750%
3-month put option on Swiss francs:
Strike rate (SFr/$) / 1.25
Premium ($/SFr) / $0.015
Tek’s weighted average cost of capital / 9.80%
Tek’s expected spot rate in 90 days (SFr/$) / 1.22
Hedging Alternatives / Value / Certainty?
1. Do Nothing—Remain Uncovered.
If the ending spot rate is the same as current spot rate (SFr/$) / $4,012,197.08 / Risky
If the ending spot rate is the same as forward (SKr/$) / $4,022,849.79 / Risky
Realistically, the ending spot rate could vary between SFr1 and SFr2 per $.
2. Sell Swiss francs forward
Sold forward 3-months at forward rate (SFr/$) / $4,022,849.79 / Certain
Problem 8.9 Tek: Swiss dividend payable (Continued)
3. Money Market Hedge
Borrow SFr now against future receipt
Principal / SFr. 5,000,000
Borrow SFr at SFr interest rate for 90-days / 0.9907
SFr proceeds received now via borrowing / SFr. 4,953,560
Exchanged into US$at spot rate of (SFr/$) / 1.25
Dollars received now / $3,974,932.09
Carry-forward rate for US$at Tek’s WACC for 90-days / 1.0245
Money Market Hedged proceeds in 90 days / $4,072,317.93
4. Buy a 3-month put option on Swiss francs / If exercised / If not exercised
Proceeds option – premium, if exercised (minimum)
Effective exchange rate if exercised/not exercised, SFr/$ / 1.25 / 1.22
Principal of payment, SFr / SFr. 5,000,000 / SFr. 5,000,000
If exercised, it will yield a gross dollar amount of / $4,000,000.00 / $4,098,360.66
Put option premium / $75,000.00 / $75,000.00
Opportunity cost of premium / 1,837.50 / 1,837.50
Total future value of premium / $76,837.50 / $76,837.50
Minimum net dollar proceeds at end of 90 days / $3,923,162.50 / $4,021,523.16
(exercised gross amount less future value of premium) / Minimum
Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.20/$or stronger to end up superior to the Money Market Hedge.)
Chapter 8 Transaction Exposure 1
Problem 8.10 Northern RainwearHedging foreign exchange risk: A/R & forward points
Assumptions / Values / Forward
Discount
Spot rate, DKr/C$ / 4.70
3-month forward rate, DKr/C$ / 4.71 / –0.85%
6-month forward rate, DKr/C$ / 4.72 / –0.85%
12-month forward rate, DKr/C$ / 4.74 / –0.84%
Northern’s Exposures / 0–90 days / 91–180 days / > 180 days
A/R due in 3 months, DKr / 3,000,000
A/R due in 6 months, DKr / 2,000,000
A/R due in 12-months, DKr / 1,000,000
Northern’s Manadatory Forward Cover / 0–90 days / 91–180 days / > 180 days
Paying the points forward / 75% / 60% / 50%
Receiving the points forward / 100% / 90% / 50%
Analysis & Exposure Management
The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$forward.
Northern Rainwear is receiving foreign currency, DKr, at future dates (“long DKr”).
Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD.
Required Forward Cover for Northern: / 0–90 days / 91–180 days / > 180 days
A/R due in 3 months, DKr / 75%
A/R due in 6 months, DKr / 60%
A/R due in 12-months, DKr / 50%
DKr Forward Cover
A/R due in 3 months, DKr / 2,250,000
A/R due in 6 months, DKr / 1,200,000
A/R due in 12-months, DKr / 500,000
Expected Canadian dollar value of DKr sold forward / 477,707.01 / 254,237.29 / 105,485.23
Chapter 8 Transaction Exposure 1
Problem 8.11 Vamo Road IndustriesHedging foreign exchange risk: a payable
Assumptions / Values
Construction payment due in six-months (A/P, quetzals) / 8,400,000
Present spot rate (quetzals/$) / 7.0000
Six-month forward rate (quetzals/$) / 7.1000
Guatemalan six-month interest rate (per annum) / 14.000%
U.S. dollar six-month interest rate (per annum) / 6.000%
Vamo’s weighted average cost of capital (WACC) / 20.000%
Expected spot rate in six-months (quetzals/$):
Highest expected rate / 8.0000
Expected rate / 7.3000
Lowest expected rate / 6.4000
a) What realistic alternatives are available to Vamo? / Cost / Certainty
1. Wait six months and make payment at spot rate
Highest expected rate / $1,050,000.00 / Risky
Expected rate / $1,150,684.93 / Risky
Lowest expected rate / $1,312,500.00 / Risky
2. Purchase quetzals forward six-months / $1,183,098.59 / Certain
(A/P divided by the forward rate)
3. Transfer dollars to quetzals today, invest for six-months
quetzals needed today (A/P discounted 180 days) / 7,850,467.29
Cost in dollars today (quetzals to $at spot rate) / $1,121,495.33
factor to carry dollars forward 180 days (1 (WACC/2)) / 1.10
Cost in dollars in six-months ($carried forward 180 days ) / $1,233,644.86 / Certain
The second choice, the forward contract, results in the lowest cost alternative among
certain alternatives.
Chapter 8 Transaction Exposure 1
Problem 8.12 Worldwide Travel’s acquisitionHedging foreign exchange risk: a payable
Assumptions / Values
Acquisition price & 3-month A/P, NewTaiwan dollars (T$) / 7,000,000
Spot rate (T$/$) / 33.40
3-month forward rate (T$/$) / 32.40
3-month Taiwan dollar deposit rate / 1.500%
3-month dollar borrowing rate / 6.500%
3-month call option on T$ / not available
Evaluation of Alternatives / Cost / Certainty
1. Do Nothing—Wait 3 months and buy T$spot
If spot rate is the same as current spot rate / $209,580.84 / Risky
If spot rate is the same as 3-month forward rate / $216,049.38 / Risky
Although this would do nothing to cover the currency risk,
there would be no required payment or borrowing for 3-months.
2. Buy T$forward 3-months
Assured cost of T$at 3-month forward rate / $216,049.38 / Certain
The purchase of a forward contract would not require any cash
up-front, but the Bank of Hawaii would reduce his available credit
line by the amount of the forward. This is a non-cash expense.
3. Money Market Hedge: Exchanging US$for T$now, depositing for 3-months until payment
Acquisition price in T$needed in 3-months / 7,000,000
Discounted back 3-months at T$deposit rate / 0.9963
Amount of NT$needed now for deposit / 6,973,848
Spot rate, T$/$ / 33.40
US$needed now for exchange / $208,797.85
US$carry-forward rate (3-month dollar borrowing rate) / 6.500% / Certain
Carry-forward factor of US$for 3-month period / 1.0163
Total cost in US$of settling A/P in 3-months with / $212,190.81
Money Market Hedge
The currency risk is eliminated, but since Matt Morita would have to exchange the money up-front, it requires Matt Morita to increase his debt outstanding for the entire 3 months.
Forward contract hedge is probably the best “acceptable” alternative.
Chapter 8 Transaction Exposure 1