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%
P & G India'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
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
P&G India's WACC carry-forward 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
P & G India'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 10.1 P & G India
Proctor and Gamble’s affiliate in India, P & G India, procures much of its toiletries product line from a Japanese company. Because of the
shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge a 8.5
million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen.
Additionally, a common practice in India is for companies like P & G India to work with a currency agent who will, in this case, lock in the
current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy.
Assumptions
Value
US dollar debt taken out in June 1997
$
50,000,000
US dollar borrowing rate on debt
8.400%
Initial spot exchange rate, baht/dollar, June 1997
25.00
Average spot exchange rate, baht/dollar, June 1998
42.00
Calculation of Foreign Exhange Loss on Repayment of Loan
At the time the loan was acquired, the scheduled repayment of dollar
and baht amounts would have been as follows:
Scheduled Repayment:
Repayment of US dollar debt: Principal
$
50,000,000
Repayment of US dollar debt: Interest
4,200,000
Total repayment
$
54,200,000
Exchange rate at time of repayment, baht/dollar
25.00
Total repayment in Thai baht
1,355,000,000
Total proceeds from loan, up-front, in Thai baht
1,250,000,000
Net interest to be paid, in Thai baht
105,000,000
Actual Repayment:
Repayment of US dollar debt: Principal
$
50,000,000
Repayment of US dollar debt: Interest
4,200,000
Total repayment
$
54,200,000
Exchange rate at time of repayment, baht/dollar
42.00
Total repayment in Thai baht
2,276,400,000
Less what Siam had EXPECTED or SCHEDULED to be repaid
(1,355,000,000)
Amount of foreign exchange loss on debt
921,400,000
Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the
Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s,
taking on massive quantities of foreign currency denominated debt (primarily U.S. dollars). When the Thai
baht (B)was devalued from its pegged rate of B25.0/$ in July 1997, Siam’s interest payments alone were
over $900 million on its outstanding dollar debt (with an average interest rate of 8.40% on its U.S. dollar
debt at that time). Assuming Siam Cement took out $50 million in debt in June 1997 at 8.40% interest, and
had to repay it in one year when the spot exchange rate had stabilized at B42.0/$, what was the foreign
exchange loss incurred on the transaction?
Spot rate, ¥/$
¥111.40/$
30-day forward rate, ¥/$
¥111.00/$
90-day forward rate, ¥/$
¥110.40/$
180-day forward rate, ¥/$
¥109.20/$
Numata's WACC
8.850%
BioTron Medical's WACC
9.200%
Assumptions
Values
BioTron's 30-day account receivable, Japanese yen
12,500,000
Spot rate, ¥/$
111.40
30-day forward rate, ¥/$
111.00
90-day forward rate, ¥/$
110.40
180-day forward rate, ¥/$
109.20
Numata's WACC
8.850%
BioTron Medical's WACC
9.200%
Desired discount on purchase price by Numata
4.500%
Brent Bush should compare two basic alternatives, both of which eliminate the currency risk.
1. Allow the discount and receive payment in Japanese yen in cash
Account recievable (yen)
12,500,000
Discount for cash payment up-front (4.500%)
(562,500)
Amount paid in cash net of discount
11,937,500
Current spot rate
111.40
Amount received in U.S. dollars by Seattle Scientific
$
107,158.89
2. Not offer any discounts for early payment and cover exposure with forwards
Account receivable (yen)
12,500,000
30-day forward rate
111.00
Amount received in cash in dollars, in 30 days
$
112,612.61
Discount factor for 30 days @ Seattle's WACC
0.9924
Present value of dollar cash received
$
111,755.82
Brent Bush should politely decline Numata's offer to pay cash in exchange for the requested discount.
Problem 10.3 BioTron Medical, Inc.
How much in U.S. dollars will BioTron Medical receive 1) with the discount and 2) with no discount but fully
covered with a forward contract?
Brent Bush, CFO of a medical device manufacturer, BioTron Medical, Inc., was approached by a Japanese
customer, Numata, with a proposal to pay cash (in yen) for its typical orders of ¥12,500,000 every other month
if it were given a 4.5% discount. Numata's current terms are 30 days with no discounts. Using the following
quotes and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments
with forward contracts.
Assumptions
Values
Receivable due in one year, US dollars
$80,000,000
Payable due in one year, US dollars
$20,000,000
Spot rate, reais per dollar (R$/$)
1.8240
One-year US dollar eurocurrency interest rate
4.00%
One-year Brazilian govt deposit note
10.50%
Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ )
1.9380
Risk
Analysis
Values
Assessment
Net exposure at time of cash settlements:
One year A/R due
$80,000,000
One year A/P due
($20,000,000)
Net exposure
$60,000,000
Certain
Cash settlement of the net position:
Brazilian reais in one year at current spot rate
R$ 109,440,000.00
Risky
Brazilian reais in one year at one year forward rate
R$ 116,280,000.00
Certain
Problem 10.4 Embraer of Brazil
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian reais, that
it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian
companies is considered a very good thing.
Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other).
Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100
people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one
year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs –
it must pay foreign suppliers $20 million for inputs one year from now (but they will be delivering the sub-components
throughout the year). The current spot rate on the Brazilian real (R$) is R$1.8240/$, but it has been steadily appreciating
against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and considered expensive. Citibank
Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the
current 4.00% U.S. dollar eurocurrency rate and the 10.50% Brazilian government deposit note.
In this case, however, because the reais is selling forward at a considerable discount, the net long position -- if sold forward --
yields considerably more reais than the current spot rate. It should also be noted, however, that if the reais were to fall
considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.
Assumptions
Values
At Spot
Receivable due in 3 months, in Indonesian rupiah (Rp)
Rp1,650,000,000
$174,603.17
Spot rate (Rp/$)
9,450
Expected spot rate in 90 days (Rp/$)
9,400
3-month forward rate (Rp/$)
9,950
Minimum dollar amount acceptable at settlement
$168,000.00
Risk
Alternatives
Values
Assessment
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
If spot rate in 90 days is same as current
$174,603.17
Risky
(Rp 1,650,000,000 / Rp 9,450/$)
If spot rate in 90 days is Rp9,400/$
$175,531.91
Risky
(Rp 1,650,000,000 / Rp 9,400/$)
If spot rate in 90 days is Rp9,800/$
$165,829.15
Risky
(Rp 1,650,000,000 / Rp 9,950/$)
2. Sell Indonesian rupiah forward.
A/R sold forward 90 days
$165,829.15
Certain
"Cost of cover" is the forward discount on Rp
-20.1%
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Vizor will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
a forward cover.
Problem 10.5 Vizor Pharmaceuticals
Vizor Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its
cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million
Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000.
Although not a big sale by company standards, company policy dictates that sales must be settled for at least a
minimum gross margin, in this case, a cash settlement of $168,000. The current 90-day forward rate is Rp9,950/$.
Although this rate appeared unattractive, Vizor had to contact several major banks before even finding a forward
quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold
relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and
make a hedging recommendation.
Current spot rate ($/€) $1.4158
Credit Suisse 90-day forward rate ($/€) $1.4172
Barclays 90-day forward rate ($/€) $1.4195
Mattel Toys WACC ($) 9.600%
90-day eurodollar interest rate 4.000%
90-day euro interest rate 3.885%
90-day eurodollar borrowing rate 5.000%
90-day euro borrowing rate 5.000%
Assumptions Values
90-day A/R (€) € 30,000,000.00
Current spot rate ($/€) $1.4158
Credit Suisse 90-day forward rate ($/€) $1.4172
Barclays 90-day forward rate ($/€) $1.4195
Expected spot rate in 90 days ($/€) $1.4200
90-day eurodollar interest rate 4.000%
90-day euro interest rate 3.885%
Implied 90-day forward rate (calculated, $/€) $1.4162
90-day eurodollar borrowing rate 5.000%
90-day euro borrowing rate 5.000%
Mattel Toys weighted average cost of capital ($) 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 $42,474,000.00 Risky If spot rate in 90 days is same as Credit Suisse forward rate $42,516,000.00 Risky If spot rate in 90 days is same as Barclays forward rate $42,585,000.00 Risky If spot rate in 90 days is expected spot rate $42,600,000.00 Risky 2. Sell euros forward 90 days
Settlement amount at Credit Suisse forward rate $42,516,000.00 Certain Settlement amount at Barclays forward rate $42,585,000.00 Certain 3. Money Market Hedge
Principal A/R in euros € 30,000,000.00
discount factor for euro borrowing rate for 90 days 0.9877 1/(1 + (.05 x 90/360)) Borrow euros against 90-day A/R € 29,629,629.63
Current spot rate, $/euro $1.4158
US dollar current value $41,949,629.63
Mattel's WACC carry-forward factor for 90 days 1.0240 1 + (.0960 x 90/360) Future value of money market hedge $42,956,420.74 Certain Evaluation of Alternatives
Problem 10.6 Mattel Toys
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).
Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, €30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattel’s treasury team has collected the following currency and market quotes. The company’s foreign exchange advisors believe the euro will be at about $1.4200/€ in 90 days. Mattel’s management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable.
111
Assumptions Values
Purchase price of Korean manufacturer, in Korean won 7,500,000,000
Less initial payment, in Korean won (1,000,000,000)
Net settlement needed, in Korean won, in six months 6,500,000,000
Current spot rate (Won/$) 1,110
Six month forward rate (Won/$) 1,175
Bobcat's cost of capital (WACC) 10.00%
Options on Korean won: Call Option Put Option
Strike price, won 1,200.00 1,200.00
Option premium (percent) 3.000% 2.400%
United States Korea
Six-month investment (not borrowing) interest rate (per annum) 4.000% 16.000%
Borrowing premium of 2.000% 2.000% 2.000%
Six-month borrowing rate (per annum) 6.000% 18.000%
Risk Management Alternatives Values Certainty
1. Remain uncovered, making the won payment in 6 months at the spot rate in effect at that date
Account payable (won) 6,500,000,000
Possible spot rate in six months: current spot rate (won/$) 1,110
Cost of settlement in six months (US$) $ 5,855,855.86 Uncertain.
Account payable (won) 6,500,000,000
Possible spot rate in six months: forward rate (won/$) 1,175
Cost of settlement in six months (US$) $ 5,531,914.89 Uncertain.
2. Forward market hedge. Buy won forward six months
Account payable (won) 6,500,000,000
Forward rate (won/$) 1,175.00
Cost of settlement in six months (US$) $ 5,531,914.89 Certain.
3. Money market hedge. Exchange dollars for won now, invest for six months.
Account payable (won) 6,500,000,000
Discount factor at the won interest rate for 6 months 1.080
Won needed now (payable/discount factor) 6,018,518,518.52
Current spot rate (won/$) 1,110.00
US dollars needed now $ 5,422,088.76
Carry forward rate for six months (WACC) 1.050
US dollar cost, in six months, of settlement $ 5,693,193.19 Certain.
4. Call option hedge. (Need to buy won = call on won)
If exercised If not exercised
Option principal 6,500,000,000
Current spot rate (won/$) 1,110.00 1,300.00
Premium cost of option (%) 3.000%
Option premium (principal/spot rate x % pm) $ 175,675.68
If option exercised/not exercised, dollar cost of won $ 5,416,666.67 $ 5,000,000.00
Premium carried forward six months (pm x 1.125, WACC) 184,459.459 184,459.46
Total net cost of call option hedge if exercised $ 5,601,126.13 $ 5,184,459.46
Maximum.
Problem 10.7 Bobcat Company
Bobcat can invest at the rates given above, or borrow at 2% per annum above those rates. Bobcat's weighted average cost of capital is 10%. Compare alternate ways that Bobcat might deal with its foreign exchange exposure. What do you recommend and why?
The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be a weaker Won, Won1,200/$ or higher, then the call option would be a lower cost alternative. This would require, however, that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the Won did not fall to the needed level.
Bobcat Company, U.S.-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won7,500 million. Won1,000 million has already been paid, and the remaining Won6,500 million is due in six months. The current spot rate is Won1,110/$, and the 6-month forward rate is Won1,175/$. The six-month Korean won interest rate is 16% per annum, the six-six-month US dollar rate is 4% per annum. Bobcat can invest at these interest rates, or borrow at 2% per annum above those rates. A six-month call option on won with a 1200/$ strike rate has a 3.0% premium, while the six-month put option at the same strike rate has a 2.4% premium.
Spot exchange rate: ¥118.255/$ (closing mid-rates) One-month forward rate: ¥117.760/$, a 5.04% p.a. premium Three-month forward: ¥116.830/$, a 4.88% p.a. premium One-year forward: ¥112.450/$, a 5.16% p.a. premium
Money Rates United States Japan Differential
One month 4.8750% 0.09375% 4.78125% Three months 4.9375% 0.09375% 4.84375% Twelve months 5.1875% 0.31250% 4.87500%
Three-month options from Kyushu Bank: * Call option on ¥20,000,000 at exercise price of ¥118.00/$: a 1% premium.
* Put option on ¥20,000,000, at exercise price of ¥118.00/$: a 3% premium.
a) What are the costs and benefits of alternative hedges? Which would you recommend, and why? b) What is the break-even reinvestment rate when comparing forward and money market alternatives?
Assumptions Values
Amount of receivable, Japanese yen (¥) 20,000,000 Spot exchange rate at time of sale (¥/$) 118.255 Booked value of sale (amount/spot rate) $169,126.04
Days receivable due 90
Aquatech's WACC 16.0%
Competitor borrowing premium, yen (¥) 2.0%
Forward rates and premiums Forward Rate Premium
One-month forward rate (¥/$) 117.760 5.04%
Three-month forward rate (¥/$) 116.830 4.88%
One-year forward rate (¥/$) 112.450 5.16%
Investment rates, % per annum United States Japan
1 month 4.8750% 0.09375%
3 months 4.9375% 0.09375%
12 months 5.1875% 0.31250%
Purchased options Strike (yen/$) Premium
3-month call option on yen 118.000 1.0% 3-month put option on yen 118.000 3.0%
a. Alternative Hedges Values Certainty
1. Remain uncovered.
Account receivable (yen) 20,000,000
Possible spot rate in 90 days (yen/$) 118.255
Cash settlement in 90 days (US$) $169,126.04 Uncertain.
2. Forward market hedge.
Account receivable (yen) 20,000,000
Forward rate (won/$) 116.830
Cash settlement in 90 days (US$) $171,188.91 Certain.
3. Money market hedge.
Account receivable (yen) 20,000,000
Discount factor for 90 days 1.00523 1 + ((.0009375 + .02) x 90/360) Yen proceeds up front 19,895,858
Current spot rate (won/$) 118.255 US dollars received now $168,245.38
Carry forward at Aquatech's WACC 1.0400 1 + (.16 x 90/360) Proceeds in 90 days $174,975.20 Certain.
4. Put option hedge. (Need to sell yen = put on yen)
Option principal 20,000,000
Current spot rate (won/$) 118.255
Premium cost of option (%) 3.000%
Option pm (principal/spot rate x % pm) $5,073.78
If option exercised, dollar proceeds $169,491.53
Less Pm carried forward 90 days (5,276.732) 1.04 carry-forward rate Net proceeds in 90 days $164,214.79 Minimum.
The put option does not GUARANTEE the company of settling for the booked amount. The money market and forward hedges do; the money market yielding the higher proceeds.
b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate:
Money market, US$ up-front $168,245.38
Forward contract, US$, end of 90 days $171,188.91
(1 + x) 101.750% $168,245.38 (1+x) = $171,188.91 x 1.74954% For 90 days Breakeven rate, % per annum $0.06998
Problem 10.8 Aquatech
Aquatech is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 11th the company sold a system to the City of Nagasaki, Japan, for installation in Nagasaki’s famous Glover Gardens (where Puccini’s Madame Butterfly waited for the return of Lt. Pinkerton.) The sale was priced in yen at ¥20,000,000, with payment due in three months.
Additional information: Aquatech’s Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese money rate. Aquatech's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable.
Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot ¥118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from ¥118.30/$ to ¥117.550/$.
Compass Rose's Manadatory Forward Cover
0-90 days
91-180 days
> 180 days
Paying the points forward
75%
60%
50%
Receiving the points forward
100%
90%
50%
Forward
Assumptions
Values
Discount
Spot rate, DKr/C$
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%
South Face'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
Analysis & Exposure Management
The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward.
Compass Rose is receiving foreign currency, DKr, at future dates ("long DKr").
Compass Rose is therefore expecting to PAY THE POINTS FORWARD.
Required Forward Cover for Compass Rose:
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
Problem 10.9 Compass Rose
Compass Rose, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date
of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory
forward contract cover formula:
Compass Rose expects to receive multiple payments in Danish kroner over the next year. DKr 3,000,000 is due in 90 days; DKr
2,000,000 is due in 180 days; and DKr 1,000,000 is due in one year. Using the following spot and forward exchange rates, what
would be the amount of forward cover required by company policy by period?
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
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
Thomas Carson's credit line with Bank of Hawaii $ 200,000
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
Discussion.
This is a difficult decision. The forward contract appears to be the preferable choice, protecting him against an appreciating T$, and creating a certain cash purchase payment. The problem, however, will be whether the Bank of Hawaii will allow him to purchase a forward for the full $216,049.38, which is slightly above his credit line currently in place. If his relationship is good with the bank, they most likely would increase his line sufficiently to allow the forward contract.
Problem 10.10 Pupule Travel
The currency risk is eliminated, but since Thomas Carson would have to exchange the money up front, it would require him to borrow the money, increasing his debt outstanding for the entire 3 months.
Pupule Travel, a Honolulu, Hawaii – based 100% privately owned travel company has signed an agreement to acquire a 50% ownership share of Taichung Travel, a Taiwan – based privately owned travel agency specializing in servicing inbound customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (T$ 7,000,000) payable in cash in 3 months.
Thomas Carson, Pupule Travel’s owner, believes the Taiwan dollar will either remain stable or decline a little over the next 3 months. At the present spot rate of T$35/$, the amount of cash required is only $200,000 but even this relatively modest amount will need to be borrowed personally by Thomas Carson. Taiwanese interest-bearing deposits by non-residents are regulated by the government, and are currently set at 1.5% per year. He has a credit line with Bank of Hawaii for $200,000 with a current borrowing interest rate of 8% per year. He does not believe that he can calculate a credible weighted average cost of capital since he has no stock outstanding and his competitors are all also privately-owned without disclosure of their financial results. Since the acquisition would use up all his available credit, he wonders if he should hedge this transaction exposure. He has quotes from Bank of Hawaii shown in the table below.
Analyze the costs and risks of each alternative, and then make a recommendation as to which alternative Thomas Carson should choose.
Assumptions
Values
Account recievable in 90 days (€)
€ 1,560,000
Initial spot exchange rate ($/€)
$1.2224
Forward rate, 90 days ($/€)
$1.2270
Expected spot rate in 90 to 120 days ($/€): Case #1
$1.1600
Expected spot rate in 90 to 120 days ($/€): Case #2
$1.2600
Hedged
Hedged
If Chronos Time Pieces ……
the Minimum
the Maximum
Proportion of exposure to be hedged
70%
120%
Total exposure (€)
€ 1,560,000
€ 1,560,000
hedged proportion
70%
120%
Minimum hedge in euros (exposure x min prop)
€ 1,092,000
€ 1,872,000
at the forward rate ($/€)
$1.2270
$1.2270
locking in ($)
$1,339,884
$2,296,944
Case #1: Ending spot rate
Proportion uncovered (short)
€ 468,000
(€ 312,000)
If ending spot rate is ($/€)
$1.1600
$1.1600
Value of uncovered proportion ($)
$542,880
($361,920)
Value of covered proportion (from above)
$1,339,884
$2,296,944
Total net proceeds, covered + uncovered
$1,882,764
$1,935,024
Case #2: Ending spot rate
Proportion uncovered (short)
€ 468,000
(€ 312,000)
If ending spot rate is ($/€)
$1.2600
$1.2600
value of uncovered proportion ($)
$589,680
($393,120)
Value of covered position (from above)
$
1,339,884
$
2,296,944
Total net proceeds, covered + uncovered
$1,929,564
$1,903,824
Benchmark: Full (100%) forward cover
$1,914,120
$1,914,120
Problem 10.11 Chronos Time Pieces
This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for more
than the exposure (therefore creating a net short position) the firm could experience nearly unlimited losses or gains.
Chronos Time Pieces of Boston exports wrist watches to many countries, selling in local currencies to watch stores and distributors.
Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the
forward market, but occasionally with options. Chronos's foreign exchange policy is such that the 70% hedge may be increased up to a
120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has
issued a 90-day invoice to its buyer for €1,560,000. The current spot rate is $1.2224/€, the 90-day forward rate is $1.2270/€.
Chronos’s treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently believes the
euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16/€.
Construction payment due in six-months (A/P, quetzals)
8,400,000
Present spot rate (quetzals/$)
7.0000
Six-month forward rate (quetzals/$)
7.1000
Guatemalan six-month interest rate (per annum)
14.000%
U.S. dollar six-month interest rate (per annum)
6.000%
Lucky 13's weighted average cost of capital (WACC)
20.000%
Expected spot rate in six-months (quetzals/$):
Highest expected rate (reflecting a significant devaluation)
8.0000
Expected rate
7.3000
Lowest expected rate (reflecting a strengthening of the quetzal)
6.4000
What realistic alternatives are available to Lucky 13 for making payments? Which method would you select and why?
What realistic alternatives are available to Lucky 13?
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.
Problem 10.12 Lucky 13
Lucky 13's treasury manager, concerned about the Guatemalan economy, wonders if Lucky 13 should be hedging its foreign
exchange risk. The manager’s own forecast is as follows:
Lucky 13 Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment
of Q8,400,000 is due in six months. (―Q‖ is the symbol for Guatemalan quetzals.) Lucky 13 uses 20% per annum as its
weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows:
Spot Rate
Forward Rate
Days Forward
Date
Event
($/£)
($/£)
of Forward Rate
February 1
Price quotation for Pegg
1.7850
1.7771
210
March 1
Contract signed for sale
1.7465
1.7381
180
Contract amount, pounds
£1,000,000
June 1
Product shipped to Pegg
1.7689
1.7602
90
August 1
Product received by Pegg
1.7840
1.7811
30
September 1
Grand Met makes payment
1.7290
---
---Analysis
a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Pegg Metropolitan, and the shipment
is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement,
the difference being the foreign exchange gain (loss).
Value as settled
1 million pounds @ $1.7290/pound
$1,729,000
Value as booked
1 million pounds @ $1.7689/pound
$1,768,900
FX gain (loss)
($39,900)
b. The value of the foreign exchange gain (loss) will depend upon when Jason actually purchases the forward contract. Because
many firms do not define an "exposure" as arising until the date that the product is shipped (loss of physical control over
the goods) and the sale is booked on the income statement, that is a common date for the purchase of the forward contract.
Forward contract purchased on June 1
Value of forward settlement
1 million pounds @ $1.7602/pound
$1,760,200
Value as booked
1 million pounds @ $1.7689/pound
$1,768,900
FX gain (loss)
($8,700)
A more aggressive alternative is for Jason to purchase the forward contract on the date that the contract was signed, March 1,
locking-in Burton's U.S. dollar settlement amount a full 90 days earlier locking-in the transaction exposure's life span.
Forward contract purchased on March 1
Value of forward settlement
1 million pounds @ $1.7381/pound
$1,738,100
Value as booked
1 million pounds @ $1.7689/pound
$1,768,900
FX gain (loss)
($30,800)
Note that in this case if Jason had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would
have been even greater, although "fully hedged." The difference is of course the result of the forward rate changing with spot rates
and interest differentials.
Problem 10.13 Burton Manufacturing
Jason Stedman is the director of finance for Burton Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory
management. Burton’s system combines a low-cost active bar-code used on inventory (the bar-code tags emit an extremely low-grade radio
frequency) with custom-designed hardware and software which tracks the low-grade emissions for inventory control. Burton has completed the
sale of a bar-code system to a British firm, Pegg Metropolitan (UK), for a total payment of £1,000,000. The following exchange rates were
available to Burton on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days.
Assumptions Values Shipment of phosphates from Morocco, Moroccan dirhams 6,000,000
Micca's cost of capital (WACC) 14.000%
Spot exchange rate, dirhams/$ 10.00
Six-month forward rate, dirhams/$ 10.40
Options on Moroccan dirhams: Call Option Put Option
Strike price, dirhams/$ 10.00 10.00
Option premium (percent) 2.000% 3.000%
United States Morocco
Six-month interest rate for borrowing (per annum) 6.000% 8.000%
Six-month interest rate for investing (per annum) 5.000% 7.000%
Risk Management Alternatives Values Certainty
1. Remain uncovered, making the dirham payment in six months at the spot rate in effect at that date
Account payable (dirhams) 6,000,000 Possible spot rate in six months -- the current spot rate (dirhams/$) 10.00
Cost of settlement in six months (US$) $ 600,000.00 Uncertain. Account payable (dirhams) 6,000,000
Possible spot rate in six months -- forward rate (dirhams/$) 10.40
Cost of settlement in six months (US$) $ 576,923.08 Uncertain. 2. Forward market hedge. Buy dirhams forward six months.
Account payable (dirhams) 6,000,000 Six month forward rate, dirhams/$ 10.40
Cost of settlement in six months (US$) $ 576,923.08 Certain. 3. Money market hedge. Exchange dollars for dirhams now, invest for six months.
Account payable (dirhams) 6,000,000.00 Discount factor at the dirham investing rate for 6 months 1.035
Dirhams needed now for investing (payable/discount factor) 5,797,101.45 Current spot rate (dirhams/$) 10.00 US dollars needed now $ 579,710.14 Carry forward rate for six months (WACC) 1.070
US dollar cost, in six months, of settlement $ 620,289.86 Certain. 4. Call option hedge. (Need to buy dirhams = call on dirhams)
Option principal 6,000,000.00 Current spot rate, dirhams/$ 10.00
Premium cost of option 2.000%
Option premium (principal/spot rate x % pm) $ 12,000.00 If option exercised, dollar cost at strike price of 10.00 dirhams/$ $ 600,000.00 Plus premium carried forward six months (pm x 1.07, WACC) 12,840.000
Total net cost of call option hedge if exercised $ 612,840.00 Maximum.
Problem 10.14 Micca Metals, Inc.
The lowest cost certain alternative is the forward. If Micca were to expect the dirham to depreciate significantly over the next six months, it may choose the call option.
Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific precious metals and materials which are used in a variety of pigment applications in many other industries including cosmetics, appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from Morocco for 6,000,000, dirhams, payable in six months. Micca’s cost of capital is 8.600%.
Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available from Bank Al-Maghrub at a premium of 2%. Six-month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available at a premium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transaction exposure. What is your recommendation?
Assumptions Value
90-day A/R in pounds £3,000,000.00
Spot rate, US$ per pound ($/£) $1.7620
90-day forward rate, US$ per pound ($/£) $1.7550
3-month U.S. dollar investment rate 6.000%
3-month U.S. dollar borrowing rate 8.000%
3-month UK investment interest rate 8.000%
3-month UK borrowing interest rate 14.000%
Put options on the British pound: Strike rates, US$/pound ($/£)
Strike rate ($/£) $1.75
Put option premium 1.500%
Strike rate ($/£) $1.71
Put option premium 1.000%
Trident's WACC 12.000%
Maria Gonzalez's expected spot rate in 90 days, US$ per pound ($/£) $1.7850
Alternative #1: Remain Uncovered Rate ($/pound) Proceeds
Value of A/R will be (3 million pounds x ending spot rate ($/pound))
If spot rate is the same as current spot rate $1.7620 $5,286,000.00 If ending spot rate is the same as current forward rate $1.7550 $5,265,000.00 If ending spot rate is the expected spot rate $1.7850 $5,355,000.00
Alternative #2: Forward Contract Hedge Rate ($/pound) Proceeds
Sell the pounds forward 3 months, locking in the forward rate
Pound A/R at the forward rate (pounds x forward) $1.7550 $5,265,000.00
Alternative #3: Money Market Hedge Rate ($/pound) Proceeds
Borrows against the A/R, receiving £ up-front, exchanging into US$.
Amount of A/R in 90-days, in pounds £3,000,000.00
Discount factor, pound borrowing rate, for 3-months 0.9662
Proceeds of borrowing, up-front, in pounds £2,898,550.72
Exchanged to US$ at current spot rate of $1.7620
US$ received against A/R, up-front $5,107,246.38
US$ need to be carried forward for comparison:
Carry-forward rate, WACC for 90 days 1.0300
Money Market Hedge, US$, at end of 90 days $5,260,463.77
Strike Rate ($/pnd) Strike Rate ($/pnd) Alternative #4: Put Option Hedges 1.75 1.71
Option premium 1.500% 1.000%
Notional principal of option (pounds) £3,000,000.00 £3,000,000.00
Spot rate ($/pound) $1.7620 $1.7620
Option premium, US$ $79,290.00 $52,860.00
Carry-forward factor, WACC, for 90 days 1.0300 1.0300 Total premium cost, in 90 days $81,668.70 $54,445.80 Proceeds from put option if exercised $5,250,000.00 $5,130,000.00 Less cost of premium, including time-value (81,668.70) (54,445.80) Net proceeds from put options, in 90 days: Minimum $5,168,331.30 $5,075,554.20
Ending spot rate needed to be superior to forward: $1.7825 $1.7732
Proceeds from exchanging pounds for US$ spot $5,347,500.00 $5,319,600.00 Less cost of option (allowed to expire OTM) (81,668.70) (54,445.80)
Net proceeds from put option, unexercised $5,265,831.30 $5,265,154.20
Analysis: Maria Gonzalez would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is less attractive as a result of the higher borrowing costs in the U.K. now. The two put options would yield unattractive amounts if they had to be exercised. As shown, the $1.75 strike price put option would be superior to the forward if the ending spot rate were $1.7825 or higher; the $1.71 strike price would be superior to the forward if the ending spot rate were $1.7732 or higher. Trident — the same U.S.-based company discussed in this chapter, has concluded a second larger sale of telecommunications equipment to Regency (U.K.). Total payment of £3,000,000 is due in 90 days. Maria Gonzalez has also learned that Trident will only be able to borrow in the United Kingdom at 14% per annum (due to credit concerns of the British banks). Given the following exchange rates and interest rates, what transaction exposure hedge is now in Trident’s best interest?
2. Hedge in the money market. Larkin could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum.
Assumptions Values Today is May 1
90-day Forward rate, $/€ $1.1060 Exchange Rate
180-day Forward rate, $/€ $1.1130 Date ($/€)
US Treasury bill rate 3.600% April 1 $1.0800
Larkin's borrowing rate, euros, per annum 8.000% May 1 $1.1000
Larkin's cost of equity 12.000%
Options on euros Strike ($/euro) Call Option Put Option
August maturity options $1.1000 3.0% 2.0%
November maturity options $1.1000 2.6% 1.2%
Valuation of Alternative Hedges August Receivable November Receivable
Amount of receivable, in euros € 2,000,000 € 2,000,000
a. Hedge in the forward market
Amount of receivable, in euros € 2,000,000 € 2,000,000
Respective forward rates ($/€) $1.1060 $1.1130
US dollar proceeds as hedged ($) $2,212,000 $2,226,000
Carry forward to Nov 1st at WACC 1.03
---Total US$ proceeds on Nov 1st $2,278,360 $2,226,000
Total of both payments
b. Hedge in the money market
Amount of receivable, in euros € 2,000,000 € 2,000,000
Discount factor for euro funds, period 1.02 1.04
Current proceeds from discounting, euros € 1,960,784 € 1,923,077
Current spot rate ($/€) $1.1000 $1.1000
Current US dollar proceeds $2,156,863 $2,115,385
Carry forward rate for the period 1.06 1.06
US dollar proceeds on future date $2,286,275 $2,242,308
Total of both payments
c. Hedge with options
Amount of receivable, in euros € 2,000,000 € 2,000,000
Buy put options for maturities (% x spot value) ($44,000) ($26,400)
Carry forward for the period 1.06 1.06
Premium cost carried forward to Nov 1 ($46,640) ($27,984)
Gross put option value if exercised $2,200,000 $2,200,000
Carried forward 3 months to Nov 1 1.03
----Gross proceeds, Nov 1 $2,266,000 $2,200,000
Total net proceeds, after premium deduction, Nov 1
d. Do nothing (remain uncovered)
Amount of receivable, in euros € 2,000,000 € 2,000,000
Ending spot exchange rate ($/€) ??? ???
The money market hedge provides the highest certain outcome. If Larkin Hydraulics believes the euro will strengthen versus the dollar over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.
3. Hedge with foreign currency options. August put options were available at a strike price of $1.1000/€ for a premium of 2.0% per contract, and November put options were available at $1.1000/€ for a premium of 1.2%. August call options at $1.1000/€ could be purchased for a premium of 3.0%, and November call options at $1.1000/€ were available at a 2.6% premium.
4. Do nothing. Larkin could wait until the sales proceeds were received in August and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.
Problem 10.16 Larkin Hydraulics
$4,504,360
$4,528,582
$4,391,376
1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/€ and the 6-month forward quote was $1.1130/€. By the time the order was received and booked on May 1st, the euro had strengthened to $1.1000/€, so the sale was in fact worth €4,000,000 x $1.1000/€ = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless Larkin's director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible: On May 1st, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for €4,000,000, payable €2,000,000 on August 1st and €2,000,000 on November 1st. Larkin derived its price quote of €4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/€.
Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long-term debt. U.S. T-bills yield 3.6% per annum. What should Larkin do?
