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CHAPTER8MANAGEMENTOFTRANSACTIONEXPOSURE

ANSWERS&SOLUTIONSTOEND-OF-CHAPTERQUESTIONSANDPROBLEMS

QUESTIONS

1.Howwouldyoudefinetransactionexposure?Howisitdifferentfromeconomicexposure?

Answer:Transactionexposureisthesensitivityofrealizeddomesticcurrencyvaluesofthefirm’scontractualcashflowsdenominatedinforeigncurrenciestounexpectedchangesinexchangerates.Unlikeeconomicexposure,transactionexposureiswell-definedandshort-term.

2.Discussandcomparehedgingtransactionexposureusingtheforwardcontractvs.moneymarketinstruments.Whendothealternativehedgingapproachesproducethesameresult?

Answer:Hedgingtransactionexposurebyaforwardcontractisachievedbysellingorbuyingforeigncurrencyreceivablesorpayablesforward.Ontheotherhand,moneymarkethedgeisachievedbyborrowingorlendingthepresentvalueofforeigncurrencyreceivablesorpayables,therebycreatingoffsettingforeigncurrencypositions.Iftheinterestrateparityisholding,thetwohedgingmethodsareequivalent.

3.Discussandcomparethecostsofhedgingviatheforwardcontractandtheoptionscontract.

Answer:Thereisnoup-frontcostofhedgingbyforwardcontracts.Inthecaseofoptionshedging,however,hedgersshouldpaythepremiumsforthecontractsup-front.Thecostofforwardhedging,however,mayberealizedexpostwhenthehedgerregretshis/herhedgingdecision.

4.Whataretheadvantagesofacurrencyoptionscontractasahedgingtoolcomparedwiththeforwardcontract?

Answer:Themainadvantageofusingoptionscontractsforhedgingisthatthehedgercandecidewhethertoexerciseoptionsuponobservingtherealizedfutureexchangerate.Optionsthusprovideahedgeagainstexpostregretthatforwardhedgermighthavetosuffer.Hedgerscanonlyeliminatethedownsideriskwhileretainingtheupsidepotential.

5.Supposeyourcompanyhaspurchasedaputoptionontheeurotomanageexchangeexposureassociatedwithanaccountreceivabledenominatedinthatcurrency.Inthiscase,yourcompanycanbesaidtohavean‘insurance’policyonitsreceivable.Explaininwhatsensethisisso.

Answer:Yourcompanyinthiscaseknowsinadvancethatitwillreceiveacertainminimumdollaramountnomatterwhatmighthappentothe$/€exchangerate.Furthermore,iftheeuroappreciates,yourcompanywillbenefitfromtherisingeuro.

6.RecentsurveysofcorporateexchangeriskmanagementpracticesindicatethatmanyU.S.firmssimplydonothedge.Howwouldyouexplainthisresult?

Answer:Therecanbemanypossiblereasonsforthis.First,manyfirmsmayfeelthattheyarenotreallyexposedtoexchangeriskduetoproductdiversification,diversifiedmarketsfortheirproducts,etc.Second,firmsmaybeusingself-insuranceagainstexchangerisk.Third,firmsmayfeelthatshareholderscandiversifyexchangeriskthemselves,renderingcorporateriskmanagementunnecessary.

7.Shouldafirmhedge?Whyorwhynot?

Answer:Inaperfectcapitalmarket,firmsmaynotneedtohedgeexchangerisk.Butfirmscanaddtotheirvaluebyhedgingifmarketsareimperfect.First,ifmanagementknowsaboutthefirm’sexposurebetterthanshareholders,thefirm,notitsshareholders,shouldhedge.Second,firmsmaybeabletohedgeatalowercost.Third,ifdefaultcostsaresignificant,corporatehedgingcanbejustifiablebecauseitreducestheprobabilityofdefault.Fourth,ifthefirmfacesprogressivetaxes,itcanreducetaxobligationsbyhedgingwhichstabilizescorporateearnings.

8.Usinganexample,discussthepossibleeffectofhedgingonafirm’staxobligations.

Answer:Onecanuseanexamplesimilartotheonepresentedinthechapter.

9.Explaincontingentexposureanddiscusstheadvantagesofusingcurrencyoptionstomanagethistypeofcurrencyexposure.

Answer:Companiesmayencounterasituationwheretheymayormaynotfacecurrencyexposure.Inthissituation,companiesneedoptions,notobligations,tobuyorsellagivenamountofforeignexchangetheymayormaynotreceiveorhavetopay.Ifcompanieseitherhedgeusingforwardcontractsordonothedgeatall,theymayfacedefinitecurrencyexposure.

10.Explaincross-hedginganddiscussthefactorsdeterminingitseffectiveness.

Answer:Cross-hedginginvolveshedgingapositioninoneassetbytakingapositioninanotherasset.Theeffectivenessofcross-hedgingwoulddependonthestrengthandstabilityoftherelationshipbetweenthetwoassets.

PROBLEMS

1.CrayResearchsoldasupercomputertotheMaxPlanckInstituteinGermanyoncreditandinvoiced€10millionpayableinsixmonths.Currently,thesix-monthforwardexchangerateis$1.10/€andtheforeignexchangeadvisorforCrayResearchpredictsthatthespotrateislikelytobe$1.05/€insixmonths.

(a)Whatistheexpectedgain/lossfromtheforwardhedging?

(b)IfyouwerethefinancialmanagerofCrayResearch,wouldyourecommendhedgingthiseuroreceivable?Whyorwhynot?

(c)Supposetheforeignexchangeadvisorpredictsthatthefuturespotratewillbethesameastheforwardexchangeratequotedtoday.Wouldyourecommendhedginginthiscase?Whyorwhynot?

(d)Supposenowthatthefuturespotexchangerateisforecasttobe$1.17/€.Wouldyourecommendhedging?Whyorwhynot?

Solution:

(a)Expectedgain($)=10,000,000(1.10–1.05)

=10,000,000(.05)

=$500,000.

Notethatforeacheurosoldforward,CrayResearchwillreceive$1.10forsureandhastodeliveroneeurothatisexpectedtocost$1.05.

(b)IwouldrecommendhedgingbecauseCrayResearchcanincreasetheexpecteddollarreceiptby$500,000andalsoeliminatetheexchangerisk.

(c)SinceCrayResearchcaneliminateriskwithoutsacrificingdollarreceipt,Istillwouldrecommendhedging.

(d)Now,hedgingviaforwardcontractinvolvesanexpectedloss:-$700,000=10,000,000(1.10-1.17).Hedgingthusbecomesmuchlessattractive.ButifCrayResearchishighlyriskaverse,itmaystilldecidetohedge.Thedecisiontohedgethencriticallydependsonthefirm’sdegreeofriskaversion.

2.IBMpurchasedcomputerchipsfromNEC,aJapaneseelectronicsconcern,andwasbilled￥250millionpayableinthreemonths.Currently,thespotexchangerateis￥105/$andthethree-monthforwardrateis￥100/$.Thethree-monthmoneymarketinterestrateis8percentperannumintheU.S.and7percentperannuminJapan.ThemanagementofIBMdecidedtousethemoneymarkethedgetodealwiththisyenaccountpayable.

(a)Explaintheprocessofamoneymarkethedgeandcomputethedollarcostofmeetingtheyenobligation.

(b)Conductthecashflowanalysisofthemoneymarkethedge.

Solution:

(a).Let’sfirstcomputethePVof￥250million,i.e.,

250m/1.0175=￥245,700,245.70

SoiftheaboveyenamountisinvestedtodayattheJapaneseinterestrateforthreemonths,thematurityvaluewillbeexactlyequalto￥25millionwhichistheamountofpayable.

Tobuytheaboveyenamounttoday,itwillcost:

$2,340,002.34=￥245,700,245.70/105.

Thedollarcostofmeetingthisyenobligationis$2,340,002.34asoftoday.

(b)

__________________________________________________________________

Transaction CF0 CF1

__________________________________________________________________

1.Buyyensspot -$2,340,002.34

withdollars ￥245,700,245.70

2.InvestinJapan -￥245,700,245.70 ￥250,000,000

3.Payyens -￥250,000,000

Netcashflow -$2,340,002.34

__________________________________________________________________

3.YouplantovisitGeneva,Switzerlandinthreemonthstoattendaninternationalbusinessconference.YouexpecttoincurthetotalcostofSF5,000forlodging,mealsandtransportationduringyourstay.Asoftoday,thespotexchangerateis$0.60/SFandthethree-monthforwardrateis$0.63/SF.Youcanbuythethree-monthcalloptiononSFwiththeexerciserateof$0.64/SFforthepremiumof$0.05perSF.Assumethatyourexpectedfuturespotexchangerateisthesameastheforwardrate.Thethree-monthinterestrateis6percentperannumintheUnitedStatesand4percentperannuminSwitzerland.

(a)CalculateyourexpecteddollarcostofbuyingSF5,000ifyouchoosetohedgeviacalloptiononSF.

(b)CalculatethefuturedollarcostofmeetingthisSFobligationifyoudecidetohedgeusingaforwardcontract.

(c)Atwhatfuturespotexchangeratewillyoubeindifferentbetweentheforwardandoptionmarkethedges?

(d)IllustratethefuturedollarcostsofmeetingtheSFpayableagainstthefuturespotexchangerateunderboththeoptionsandforwardmarkethedges.

Solution:

(a)Totaloptionpremium=(.05)(5000)=$250.Inthreemonths,$250isworth$253.75=$250(1.015).Attheexpectedfuturespotrateof$0.63/SF,whichislessthantheexerciseprice,youdon’texpecttoexerciseoptions.Rather,youexpecttobuySwissfrancat$0.63/SF.SinceyouaregoingtobuySF5,000,youexpecttospend$3,150(=.63x5,000).Thus,thetotalexpectedcostofbuyingSF5,000willbethesumof$3,150and$253.75,i.e.,$3,403.75.

(b)$3,150=(.63)(5,000).

(c)$3,150=5,000x+253.75,wherexrepresentsthebreak-evenfuturespotrate.Solvingforx,weobtainx=$0.57925/SF.Notethatatthebreak-evenfuturespotrate,optionswillnotbeexercised.

(d)IftheSwissfrancappreciatesbeyond$0.64/SF,whichistheexercisepriceofcalloption,youwillexercisetheoptionandbuySF5,000for$3,200.ThetotalcostofbuyingSF5,000willbe$3,453.75=$3,200+$253.75.ThisisthemaximumyouwillpayforSF5,000.

$Cost

Optionshedge

Forwardhedge

$3,453.75

$3,150

0

0.579

0.64

(strikeprice)

$/SF

$253.75

4.BoeingjustsignedacontracttosellaBoeing737aircrafttoAirFrance.AirFrancewillbebilled€20millionwhichispayableinoneyear.Thecurrentspotexchangerateis$1.05/€andtheone-yearforwardrateis$1.10/€.Theannualinterestrateis6.0%intheU.S.and5.0%inFrance.Boeingisconcernedwiththevolatileexchangeratebetweenthedollarandtheeuroandwouldliketohedgeexchangeexposure.

(a)Itisconsideringtwohedgingalternatives:selltheeuroproceedsfromthesaleforwardorborroweurosfromCreditLyonnaiseagainsttheeuroreceivable.Whichalternativewouldyourecommend?Why?

(b)Otherthingsbeingequal,atwhatforwardexchangeratewouldBoeingbeindifferentbetweenthetwohedgingmethods?

Solution:

(a)Inthecaseofforwardhedge,thefuturedollarproceedswillbe(20,000,000)(1.10)=$22,000,000.Inthecaseofmoneymarkethedge(MMH),thefirmhastofirstborrowthePVofitseuroreceivable,i.e.,20,000,000/1.05=€19,047,619.Thenthefirmshouldexchangethiseuroamountintodollarsatthecurrentspotratetoreceive:(€19,047,619)($1.05/€)=$20,000,000,whichcanbeinvestedatthedollarinterestrateforoneyeartoyield:$20,000,000(1.06)=$21,200,000.Clearly,thefirmcanreceive$800,000morebyusingforwardhedging.

(b)AccordingtoIRP,F=S(1+i$)/(1+iF).Thusthe“indifferent”forwardratewillbe:

F=1.05(1.06)/1.05=$1.06/€.

5.SupposethatBaltimoreMachinerysoldadrillingmachinetoaSwissfirmandgavetheSwissclientachoiceofpayingeither$10,000orSF15,000inthreemonths.

(a)Intheaboveexample,BaltimoreMachineryeffectivelygavetheSwissclientafreeoptiontobuyupto$10,000dollarsusingSwissfranc.Whatisthe‘implied’exerciseexchangerate?

(b)Ifthespotexchangerateturnsouttobe$0.62/SF,whichcurrencydoyouthinktheSwissclientwillchoosetouseforpayment?WhatisthevalueofthisfreeoptionfortheSwissclient?

(c)WhatisthebestwayforBaltimoreMachinerytodealwiththeexchangeexposure?

Solution:

(a)Theimpliedexercise(price)rateis:10,000/15,000=$0.6667/SF.

(b)IftheSwissclientchoosestopay$10,000,itwillcostSF16,129(=10,000/.62).SincetheSwissclienthasanoptiontopaySF15,000,itwillchoosetodoso.ThevalueofthisoptionisobviouslySF1,129(=SF16,129-SF15,000).

(c)BaltimoreMachineryfacesacontingentexposureinthesensethatitmayormaynotreceiveSF15,000inthefuture.ThefirmthuscanhedgethisexposurebybuyingaputoptiononSF15,000.

6.PrincessCruiseCompany(PCC)purchasedashipfromMitsubishiHeavyIndustry.PCCowesMitsubishiHeavyIndustry500millionyeninoneyear.Thecurrentspotrateis124yenperdollarandtheone-yearforwardrateis110yenperdollar.Theannualinterestrateis5%inJapanand8%intheU.S.PCCcanalsobuyaone-yearcalloptiononyenatthestrikepriceof$.0081peryenforapremiumof.014centsperyen.

(a)Computethefuturedollarcostsofmeetingthisobligationusingthemoneymarkethedgeandtheforwardhedges.

(b)Assumingthattheforwardexchangerateisthebestpredictorofthefuturespotrate,computetheexpectedfuturedollarcostofmeetingthisobligationwhentheoptionhedgeisused.

(c)AtwhatfuturespotratedoyouthinkPCCmaybeindifferentbetweentheoptionandforwardhedge?

Solution:

(a)Inthecaseofforwardhedge,thedollarcostwillbe500,000,000/110=$4,545,455.Inthecaseofmoneymarkethedge,thefuturedollarcostwillbe:500,000,000(1.08)/(1.05)(124)

=$4,147,465.

(b)Theoptionpremiumis:(.014/100)(500,000,000)=$70,000.Itsfuturevaluewillbe$70,000(1.08)=$75,600.

Attheexpectedfuturespotrateof$.0091(=1/110),whichishigherthantheexerciseof$.0081,PCCwillexerciseitscalloptionandbuy￥500,000,000for$4,050,000(=500,000,000x.0081).

Thetotalexpectedcostwillthusbe$4,125,600,whichisthesumof$75,600and$4,050,000.

(c)Whentheoptionhedgeisused,PCCwillspend“atmost”$4,125,000.Ontheotherhand,whentheforwardhedgingisused,PCCwillhavetospend$4,545,455regardlessofthefuturespotrate.Thismeansthattheoptionshedgedominatestheforwardhedge.Atnofuturespotrate,PCCwillbeindifferentbetweenforwardandoptionshedges.

7.ConsideraU.S.-basedcompanythatexportsgoodstoSwitzerland.TheU.S.Companyexpectstoreceivepaymentonashipmentofgoodsinthreemonths.BecausethepaymentwillbeinSwissfrancs,theU.S.CompanywantstohedgeagainstadeclineinthevalueoftheSwissfrancoverthenextthreemonths.TheU.S.risk-freerateis2percent,andtheSwissrisk-freerateis5percent.Assumethatinterestratesareexpectedtoremainfixedoverthenextsixmonths.Thecurrentspotrateis$0.5974

IndicatewhethertheU.S.Companyshouldusealongorshortforwardcontracttohedgecurrencyrisk.

Calculatetheno-arbitragepriceatwhichtheU.S.Companycouldenterintoaforwardcontractthatexpiresinthreemonths.

Itisnow30dayssincetheU.S.Companyenteredintotheforwardcontract.Thespotrateis$0.55.Interestratesarethesameasbefore.CalculatethevalueoftheU.S.Company’sforwardposition.

Solution:

TherisktotheU.S.companyisthatthevalueoftheSwissfrancwilldeclineanditwillreceivefewerU.S.dollarsonconversion.Tohedgethisrisk,thecompanyshouldenterintoacontracttosellSwissfrancsforward.

S0=$0.5974

T=90/365

r=0.02

rf=0.05

St=$0.55

T=90/365

t=30/365

T–t=60/365

r=0.02

rf=0.05

Thisrepresentsagaintotheshortpositionof$0.0456perSwissfranc.Inthisproblem,theU.S.companyholdstheshortforwardposition.

8.SupposethatyouareaU.S.-basedimporterofgoodsfromtheUnitedKingdom.YouexpectthevalueofthepoundtoincreaseagainsttheU.S.dollaroverthenext30days.Youwillbemakingpaymentonashipmentofimportedgoodsin30daysandwanttohedgeyourcurrencyexposure.TheU.S.risk-freerateis5.5percent,andtheU.K.risk-freerateis4.5percent.Theseratesareexpectedtoremainunchangedoverthenextmonth.Thecurrentspotrateis$1.50.

Indicatewhetheryoushouldusealongorshortforwardcontracttohedgecurrencyrisk.

Calculatetheno-arbitragepriceatwhichyoucouldenterintoaforwardcontractthatexpiresinthreemonths.

Moveforward10days.Thespotrateis$1.53.Interestratesareunchanged.Calculatethevalueofyourforwardposition.

UsingthetextsoftwarespreadsheetTRANSEXP,replicatetheanalysisinExhibit8.8.

Solution:

TherisktoyouisthatthevalueoftheBritishpoundwillriseoverthenext30daysanditwillrequiremoreU.S.dollarstobuythenecessarypoundstomakepayment.Tohedgethisrisk,youshouldenteraforwardcontracttobuyBritishpounds.

S0=$1.50

T=30/365

r=0.055

rf=0.045

c. St=$1.53

T=30/365

t=10/365

T–t=20/365

r=0.055

rf=0.045

Becauseyouarelong,thisisagainof$0.0295perBritishpound.

d.TheanswerisprovidedinExhibit8.8ofthetextbook.

MINICASE:AIRBUS’DOLLAREXPOSURE

Airbussoldanaircraft,A400,toDeltaAirlines,aU.S.company,andbilled$30millionpayableinsixmonths.Airbusisconcernedwiththeeuroproceedsfrominternationalsalesandwouldliketocontrolexchangerisk.Thecurrentspotexchangerateis$1.05/€andsix-monthforwardexchangerateis$1.10/€atthemoment.Airbuscanbuyasix-monthputoptiononU.S.dollarswithastrikepriceof€0.95/$forapremiumof€0.02perU.S.dollar.Currently,six-monthinterestrateis2.5%intheeurozoneand3.0%intheU.S.

a. ComputetheguaranteedeuroproceedsfromtheAmericansaleifAirbusdecidestohedgeusingaforwardcontract.

b. IfAirbusdecidestohedgeusingmoneymarketinstruments,whatactiondoesAirbusneedtotake?WhatwouldbetheguaranteedeuroproceedsfromtheAmericansaleinthiscase?

c.IfAirbusdecidestohedgeusingputoptionsonU.S.dollars,whatwouldbethe‘expected’europroceedsfromtheAmericansale?AssumethatAirbusregardsthecurrentforwardexchangerateasanunbiasedpredictorofthefuturespotexchangerate.

d.AtwhatfuturespotexchangeratedoyouthinkAirbuswillbeindifferentbetweentheoptionandmoneymarkethedge?

Solution:

a.Airbuswillsell$30millionforwardfor€27,272,727=($30,000,000)/($1.10/€).

b.Airbuswillborrowthepresentvalueofthedollarreceivable,i.e.,$29,126,214=$30,000,000/1.03,andthensellthedollarproceedsspotforeuros:€27,739,251(=$29,126,214/$1.05/€).ThisistheeuroamountthatAirbusisgoingtokeep.

c.Sincetheexpectedfuturespotrateislessthanthestrikepriceoftheputoption,i.e.,€0.9091<€0.95,Airbusexpectstoexercisetheputoptionon$andreceive€28,500,000=($30,000,000)(€0.95/$).Thisisgrossproceeds.Airbusspent€600,000(=0.02x30,000,000)upfrontfortheoptionanditsfuturecostisequalto€615,000=€600,000x1.025.ThustheneteuroproceedsfromtheAmericansaleis€27,885,000,whichisthedifferencebetweenthegrossproceedsandtheoptioncosts.

d.Attheindifferentfuturespotrate,thefollowingwillhold:

€28,432,732=ST(30,000,000)-€615,000.

SolvingforST,weobtainthe“indifference”futurespotexchangerate,i.e.,€0.9683/$,or$1.0327/€.Notethat€28,432,732isthefuturevalueoftheproceedsundermoneymarkethedging:€28,432,732=(€27,739,251)(1.025).

CaseApplication:RichardMay’sOptions

ItisTuesdayafternoon,February14,2012.RichardMay,AssistantTreasureratAmericanDigitalGraphics(ADG),sitsinhisofficeonthethirty-fourthfloorofthebuildingthatdominatesRockefellerPlaza’swestperimeter.ItsValentine’sDayandRichardandhiswifehavedinnerreservationswithanothercoupleatBalthazarat7:30.“Imustgetthishedgingmemodone,”thinksMay,“andgetoutofhere.Foreignexchangeoptions?IhadbettergetthestorystraightbeforesomeoneintheFinanceCommitteestartsaskingquestions.Let’ssee,therearetwowaysinwhichIcanenvisageususingoptionsnow.OneistohedgeadividenddueonSeptember15thfromADGGermany.TheotheristohedgeourupcomingpaymenttoMatsumerdafortheirspringRAMchipstatement.Withtheyenat78andincreasingI’mgladwehaven’tcoveredthepaymentsofar,butnowI’mgettingnervousandIwouldliketoprotectmyposterior.AnoptiontobuyyenonJune10mightbejustthething.

BeforewedelveanyfurtherintoRichardMay’smusings,letuslearnabitaboutADG,andaboutforeignexchangeoptions.AmericanDigitalGraphicsisa$12billionsalescompanyengagedin,amongotherthings,thedevelopment,manufacture,andmarketingofmicroprocessor-basedequipment.Although30percentofthefirm’ssalesarecurrentlyabroad,thefirmhasfull-fledgedmanufacturingfacilitiesinonlythreeforeigncountries,Germany,Canada,andBrazil.AnassemblyplantinSingaporeexistsprimarilytosolderJapanesesemiconductorchipsontocircuitboardsandtoscrewtheseintoBrazilian-madeboxesforshipmenttotheUnitedStates,Canada,andGermany.TheGermansubsidiaryhasdevelopedhalfofitssalestoFrance,theNetherlands,andtheUnitedKingdom,billingineuros.ADGGermanyhasaccumulatedacashreserveof€900,000,worth$1,178,100attoday’sexchangerate.WhiletheHamburgofficehasautomaticpermissiontorepatriate€3million,theyhavebeenurgedtoseekauthorizationtoconvertanother€1millionbySeptember15th.ThefirmhasanagreementtobuythreehundredthousandRAMchipsat￥8000eachsemi-annually,anditisthispaymentthatwillfalldueonJune10th.

Theconventionalmeansofhedgingexchangeriskareforwardorfuturecontracts.These,however,arefixedandinviolableagreements.Inmanypracticalinstancesthehedgerisuncertainwhetherforeigncurrencycashinfloworoutflowwillmaterialize.Insuchcases,whatisneededistheright,butnottheobligation,tobuyorselladesignatedquantityofaforeigncurrencyataspecifiedprice(exchangerate).Thisispreciselywhataforeignexchangeoptionprovides.

Aforeignexchangeoptiongivestheholdertherighttobuyorselladesignatedquantityofaforeigncurrencyataspecifiedexchangerateuptooratastipulateddate.

Theterminaldateofthecontractiscalledtheexpirationdate(ormaturitydate).Iftheoptionmaybeexercisedbeforetheexpirationdate,itiscalledanAmericanoption;ifonlyattheexpirationdate,aEuropeanoption.

Thepartyretainingtheoptionistheoptionbuyer;thepartygivingtheoptionistheoptionseller(orwriter).Theexchangerateatwhichtheoptioncanbeexercisediscalledtheexercisepriceorstrikeprice.Thebuyeroftheoptionmustpaythesellersomeamount,calledtheoptionpriceorthepremium,fortherightsinvolved.

Theimportantfeatureofaforeignexchangeoptionisthattheholderoftheoptionhastheright,butnottheobligation,toexerciseit.Hewillonlyexerciseitifthecurrencymovesinafavorabledirection.Thus,onceyouhavepaidforanoptionyoucannotlose,unlikeaforwardcontract,whereyouareobligedtoexchangethecurrenciesandthereforewillloseifthemovementisunfavorable.

Thedisadvantageofanoptioncontract,comparedtoaforwardorfuturescontractisthatyouhavetopayapricefortheoption,andthispriceorpremiumtendstobequitehighforcertainoptions.Ingeneral,theoption’spricewillbehigherthegreatertherisktotheseller(andthegreaterthevaluetothebuyerbecausethisisazero-sumgame).Theriskofacalloptionwillbegreater,andthepremiumhigher,thehighertheforwardraterelativetotheexerciseprice;afterall,onecanalwayslockinaprofitbybuyingattheexercisepriceandsellingattheforwardrate.Thechancethattheoptionwillbeexercisedprofitablyisalsohigher,themorevolatileisthecurrency,andthelongertheoptionhastorunbeforeitexpires.

ReturningtoRichardMayinhisRockefellerCenteroffice,wefindthathehasbeenprintingspot,forwardandcurrencyoptionsandfuturesquotationsfromthecompany’sBloombergterminal.

TheoptionpricesarequotedinU.S.centspereuro.Yenarequotedinhundredthsofacent.Lookingattheseprices,Richardrealizesthathecanworkouthowmuchtheeurooryenwouldhavetochangetomaketheoptionworthwhile.RichardmakesamentalnotethatADGcantypicallyborrowintheEurocurrencymarketatLIBOR+1%andlendatLIBID.

“I’llattachthesenumberstomymemo,”muttersMay,butthetruthishehasyettocometogripswiththerealquestion,whichiswhen,ifever,arecurrencyoptionsabettermeansofhedgingexchangeriskforaninternationalfirmthantraditionalforwardexchangecontractsorfuture’scontracts.PleaseassistMr.MayinhisanalysisofcurrencyhedgingforhisreporttoADG’sFinanceCommittee.Indoingso,youmayconsultthehighlightedmarketquotesinthefollowingattachments.

Solution

ADG’seuroreceivable

ADGhasa€3,000,000receivablein214daysonSeptember15th.Toassessalternative

waysofhedging,thefollowingdataarerelevant:Thecurrentspotexchangerate

(S)=$1.3088/€,7-monthforwardexchangerate(F)=$1.3090,thedollarinterestrate

(bid)=0.78%andeurointerestrate(ask)=1.40%.Theputoptionontheeurowiththe

strike(exercise)priceof$1.31sellingforapremiumof5.09centspereuro.Herewe

considerandcomparethreealternativehedgingmethodsasinourdiscussionsinthe

textbook:Forward,moneymarket,andoptionhedges.Hedgingwithfuturesisoften

inconvenientduetothestandardizedmaturitiesandcontractsizeandalsopossiblythin

trading.

?Forwardhedge

IfADGchoosestouseforwardcontract,itjustneedstosellitseuroreceivableattoday’s

forwardexchange.ADGthenisassuredofreceivingaguaranteeddollaramountof

$3,927,000onSeptember15th:(€3,000,000)($1.3090/€)=$3,927,000.

?Moneymarkethedge

IfADGdecidestousemoneymarkethedging,itfirstneedstoborrowthepresentvalue

(PV)ofitseuroreceivableat2.40%interestrate(=1.40%+1.0%):

PV=(€3,000,000)/(1+0.024(214/360))=3,000,000/1.01427=€2,957,802.

Itthenwouldconvert€2,957,802attoday’sspotexchangerateof$1.3088/€into

$3,871,171.IfADGinveststhisdollaramountatthedollarinterestratetillSeptember

15th,thefuturevalue(FV)oftheinvestmentwillbe:

FV=($3,871,171)(1+0.0078(214/360))=$3,889,121.

?Optionhedge

IfADGchoosestohedgeitseuroreceivableusingcurrencyoptions,itcanpurchaseput