College of Business Administration
International Finance
ASSIGNMENT 2
Abdullah Al Zahrani
200700660
Problem 1
Case: Real Cost of hedging a 90-day payable of 200,000 British Pound
John Co. negotiates a forward contract to buy 200,000 British Pound allowing the firm to lock in a
specific exchange rate at which it can purchase British Pound in 90 days.
John Co. will need 200,000 British Pound in 90 days to pay suppliers and the forward
rate in 90 days is $1.42, it can obtain a forward contract to purchase 200,000 British Pound in 90
days at $1.42. If John Co. purchase British Pound in 90 days forward, John will cost him
$284,000 (200,000 British Pounds x $1.42).
John Co. may decide not to hedge its 200,000 British Pounds payables. The company will be
exposed to the possible appreciation of the British Pound. In case the British Pound
appreciates, John Co. will lose profit.
If the prevailing spot rate after 90 days is $1.40, John Co will purchase British Pound in
the foreign exchange market at $1.40 per unit, thus paying a total of $280,000 (200,000 x $1.40)
Real Cost of Hedging Payables- To evaluate the hedging decision if it is effective or not, John
Co. compares the amount paid for the 200,000 British Pounds if hedging was used and
the amount paid for the same payable if hedging was not used.
If John Co. negotiates a forward contract to buy 200,000 British Pounds, the company
will pay $284,000. If John Co. did not hedge, the company will pay $280,000. The real cost of
hedging is $4,000 ($284,000 - $280,000). Therefore, the forward hedge is not effective because
John Co. paid more.
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Problem 2:
Introduction
Jaffrey Co, a MNC located in US, is exposed to risk called transaction exposure.
Transaction exposure is the probability of gains and losses that come from the future settlement
of transactions denominated in foreign currency. The value of Jaffrey’s cash inflows from its
receivables denominated in Singapore Dollars depends on the value of exchange rates at the time
they are received. Jaffrey Co. can hedge its transaction exposure from the possible depreciation
of Singapore Dollars using several techniques.
Case: Hedging a one-year receivable of S$400,000
Solution 1: Jaffrey Co. can negotiate a forward contract to sell Singapore Dollars allowing the
firm to lock in a specific exchange rate at which it can sell the Singapore Dollars.
Jaffrey Co. is expecting to receive S$400,000 and the forward rate in one year is $0.60, it
can obtain a forward contract to sell S$400,000 in one year. If Jaffrey Co. sells Singapore
Dollars in one year forward, the amount of dollars to be received with certainty in one year is
$240,000 (S$400,000 x $0.60).
The forward contract allows Jaffrey Co. to sell its foreign currency receivables thereby
locking in a future exchange rate today so that profits will not be affected with changes in the
exchange rate in the future. This technique completely eliminates transaction exposure but
Jaffrey Co. will not benefit from favorable changes in exchange rate.
Solution 2: Jaffrey can use money market hedge by borrowing Singapore Dollars, convert the
Singapore Dollars into USD and invest the USD in a US Bank. When the receivables are
due, Jaffrey Co. can pay the bank loan with the foreign denominated receivables.
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Jaffrey Co is expecting to receive S$400,000 in one year; Jaffrey Co. can borrow
Singapore Dollars at 5% for one year. The amount that can be borrowed to settle the receivables
will be S$ 380,952.38 (S$ 400,000/ (1+.05). In this case, Jaffrey Co. obtains a one-year loan of
S$380,952.38 from a bank; it owes the bank a total of S$400,000 in one year. The receivables of
S$400,000 will be used to repay the loan.
The loan amount received of S$380,952.38 can be converted into dollars and invested in
US Bank to earn profit. If the spot rate is $0.62, the amount of USD received from the loan is
USD 236,190.48. If Jaffrey Co. can earn 7% over a period of one year in a US Bank, the
investment will be worth USD 252,723.81 (USD 236,190.48 x 1.07). Thus, the receivable is
worth USD 252,723.81 in one year.
Solution 3: Jaffrey can buy a put option to hedge the S$400,000 receivables. Jaffrey can
purchase a put option on S$400,000 and lock in the amount that it would receive when
converting the receivables denominated in Singapore Dollars into USD.
The put option has an exercise price of $0.63 and a premium of $0.02 and the expiration
date is one year. At any spot rate more than the exercise price, Jaffrey Co. will let the put option
expire and would sell the Singapore Dollar at the spot rate in the foreign currency market. At
any spot rate less than or equal to the exercise price of $0.63, Jaffrey Co. will exercise the put
option and would sell the Singapore Dollars at the exercise price of $0.63. After subtracting the
$0.02 premium per unit, Jaffrey will receive $0.61 per unit from selling the Singapore Dollars.
The spot rate after one year is $0.63, Jaffrey Co will receive USD 244,000 ($0.61 x S$400,000).
The currency option offers to limit the losses that the company may incur due to adverse
exchange rate changes but Jaffrey Co. has to pay a premium for the option.
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Optimal Technique for Hedging Receivables: The Money Market Hedge is the optimal
technique for hedging the S$400,000 receivables because it generates the highest amount
of dollars.
Forward hedge = USD 240,000.00
Money market hedge = USD 252,723.81
Currency option hedge = USD 244,000
Solution 4: No Hedge- Jaffrey Co. can choose not to hedge its S$400,000 receivables. This
technique exposes the company from possible depreciation of the Singapore Dollar.
Jaffrey Co. assumes high risk from the possibility of losing from this exposure. However,
if the value of Singapore Dollar appreciates in the future, Jaffrey Co. will gain more
because the company did not pay for any premium as in the case of put option.
If the spot rate is $0.63 after one year, Jaffrey Co. will receive an equivalent of $252,000
from its S$400,000 receivables (S$400,000 x $0.63).
Evaluation of Optimal Hedging Technique: Cost of Hedging – The effectiveness of a hedging
technique is evaluated by making a comparison between the amount received when
hedging is used and the amount received when the firm did not hedge at all. The optimal
hedging technique is the money market hedge and gives Jaffrey Co a total cash inflow of
USD 252,723.81, if Jaffrey Co. did not hedge its receivables, the company receives
$252,000. Jaffrey Co. receives $723.81 more when money market hedge is used.
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