Chapter 8
Transaction Exposure
T Questions
Foreign exchange exposure
1.
Give a general definition of “foreign exchange exposure” as it relates to the operations of a
multinational enterprise.
In its most general sense, foreign exchange exposure is the possibility of either beneficial or harmful
effects on a company caused by a change in foreign exchange rates. The effect on the company may
be on its profits, its cash flows, or its market value.
Exposure types
2.
Explain the differences among transaction, operating, and translation exposure.
(a) Transaction exposure is the potential for a gain or loss in contracted-for near term cash flows
caused by a foreign exchange rate-induced change in the value of amounts due to the MNE or
amounts that the MNE owes to other parties. As such, it is a change in the home currency value
of cash flows that are already contracted for.
(b) Operating exposure is the potential for a change in the value of a MNE, usually viewed as the
present value of all future cash inflows, caused by unexpected exchange rate changes. As such, it
is a change in expected long-term cash flows; i.e., future cash flows expected in the course of
normal business but not yet contracted for.
(c) Translation exposure is the possibility of a change in the equity section (common stock, retained
earnings, and equity reserves) of a MNE’s consolidated balance sheet, caused by a change
(expected or not expected) in foreign exchange rates. As such it is not a cash flow change, but is
rather the result of consolidating into one parent company’s financial statement the individual
financial statements of related subsidiaries and affiliates.
Translation versus transaction exposure
3.
Is there any difference between translation exposure and transaction exposure? Explain.
Translation exposure measures accounting (book) gains and losses from a change in exchange rates.
Transaction exposure measures cash (realized) gains and losses from a change in exchange rates.
Chapter 8
Transaction Exposure
133
Tax exposure
4.
What is tax exposure and how does it relate to the triumvirate of transaction, operating, and
translation exposure?
Tax exposure is separate from the triumvirate of transaction, operating, and accounting exposure
because it basically the tax consequences of a gain or loss caused by this triumvirate. Transaction
exposure is a cash loss and so results in a tax savings—in the sense that a lowering of profits because
of a transaction loss lowers income taxes, other things being equal. Any loss from operating exposure
is difficult to measure; a resultant drop in market value of a MNE’s shares has no tax consequences
for the company—although it may have tax consequences for investors holding the shares. To the
extent that operating exposure causes a lowering of corporate profits in future years, taxes in those
years are reduced. Translation exposure is a measurement loss, rather than a cash loss, and so has no
tax consequences.
Hedging
5.
What is a hedge?
A “hedge” is the acquisition of a contract or a physical asset that will offset a change in value of some
other contract or physical asset. Hedges are entered into to reduce or eliminate risk.
Cash flow variability
6.
Exhibit 8.2 in the text shows two normal distributions about a mean called expected value.
(a) The areas toward the center of the distributions where the “hedged” line is higher than the
“unhedged” line, implies that a greater proportion of expected values will be near the expected
mean value when the cash flows are hedged. Variability of expected results is reduced.
(b) The areas toward the outlying edges of the distributions, where the “unhedged” line is higher
than the “hedged” line, imply that a greater likelihood exists for significantly higher cash flows
as well as significantly lower cash flows than exist when the cash flows are hedged.
(c) Hedging is not cost free; something is paid to obtain the hedge. Hence the expected value for
hedged cash flows should be that of the unhedged cash flow less the cost of the hedge. Thus one
might argue that the mean expected value of the hedged cash flow should be to the left of that for
the unhedged cash flow. (No reason exists for the mean cash flow of the hedged flows to be to
the right of that for the unhedged cash flows.)
Investor expectations
7.
Proponents of the efficient market hypothesis argue that an MNE should not hedge because investors
can hedge themselves if they do not like the foreign exchange risks carried by the firm. Assess this
argument.
Proponents of the efficient market hypothesis believe that the current market price of a MNE’s shares
of stock fully and appropriately discounts all the risks of the firm, including foreign exchange risk,
and that the firm should not pay the cash cost of hedging because investors can individually hedge or
not as they see fit, and that the present share price already reflects this risk. These proponents also
argue that the propensity to carry risk is different for management than for shareholders, and that risk
hedging is often undertaken by management to protect its own interests, which differ from the
interests of shareholders. Lastly they argue that management is more likely to hedge accounting risks,
which are more precisely measured, than operating risks, which are conceptual and deal with future
expectations.
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Moffett • Fundamentals of Multinational Finance, Second Edition
The argument that management might appropriately hedge its foreign currency risks is based on the
logic that management has firsthand knowledge of foreign currency risks, that the nature and
magnitude of these risks change from day to day (or at least month to month), and that the specifics
of such risks cannot be known (and so discounted) by the impersonal forces of an “efficient” market.
Other arguments in favor of hedging include improved cash flow management for the firm and the
need to preserve liquidity for debt service and/or unexpected variations in near-term cash flows.
Creating transaction exposure
8.
Identify and create a hypothetical example for each of the four causes of transaction exposure.
Assume a hypothetical U.S. company named Smith Company.
(a) Purchasing or selling on open account. Smith Company sells goods to a buyer in Great Britain
with the sale denominated in British pounds sterling and payment due in 60 days. When Smith
Company receives the pounds sterling 60 days after the sale, the U.S. dollar value of those
pounds may be less, or more, than was expected at the time of sale.
(b) Borrowing and lending. Smith Company finds that it can borrow Swiss francs at 4% per annum
interest, and exchange them for the needed U.S. dollars, whereas borrowing dollars in the U.S.
will cost 7% per annum. Hence it borrows Swiss francs for one year in order to “save” on the
interest cost. One year hence the Swiss franc has strengthened against the dollar by more than the
3% interest differential, and the Swiss franc borrowing ends up costing more than 7% in U.S.
dollar terms.
(c) Owning an unperformed foreign exchange forward contract. Believing that the Japanese yen will
weaken within three months, Smith Company decides to speculate by selling yen forward. It
hopes to profit by buying the yen to deliver against this forward sale at a cheaper exchange rate
in three months. In fact the yen strengthens and Smith Company must buy yen to cover its
forward yen obligation at a price higher than will be received via the forward sale.
(d) Acquiring assets or incurring liabilities denominated in foreign currencies. Having excess cash
and faced with euro interest rates of 8% and U.S. rates of 5%, Smith Company invests the cash in
euro money market obligations. At maturity the euro has weakened by more than three
percentage points and Smith Company ends up earning in dollars less than the 5% it could have
earned by investing in a U.S. dollar asset.
Cash balances
9.
Why does the holding of foreign currency cash balances not lead to transaction exposure?
Transaction exposure arises from the payment of one currency to a party wanting, in the end, a
different currency. Thus a movement of currency value from one currency to another is required.
Foreign currency cash balances held for operating purposes by a foreign subsidiary are not inherently
intended for exchange for another currency, nor is such an exchange required. Hence they do not
create transaction exposure. (They do, however, create translation exposure.)
Chapter 8
Transaction Exposure
135
Natural vs. contractual hedges
10. Explain the difference between a natural hedge and a contractual hedge. Give a hypothetical example.
A natural hedge is one that results from matching foreign currency cash flows that come about from
the normal operations of a MNE. An example would be for a MNE that had euro operating inflows
from sales to borrow an equivalent amount of euros to finance working capital. Should the dollar/euro
exchange rate change, any gain or loss from the euro operating inflows would be offset by a loss or
gain on the euro borrowing. In effect, the euro operating inflows would be used to pay the euro debt.
Any foreign exchange transaction is avoided.
A contractual hedge is a contract specifically entered into as a financial rather than operating hedge.
Examples are forward and future foreign exchange agreements, money market hedges, and the
purchase of options.
Risk tolerance
11. What is risk tolerance? Can it be measured?
Risk tolerance is the psychological or philosophical willingness of a firm, or of its managers, to bear
risk. As such, it cannot be measured or quantified, although observations and comparisons of
management decisions over time can provide a rough inkling of such managements’ risk tolerance.
Variations in risk tolerance reflect the fact that different individuals have different opinions about
whether or not a risk is worth bearing, or conversely, whether or not a risk should be left open ended
or hedged.
T Mini-Case: Lufthansa’s Purchase of Boeing 737s
1.
Do you think Heinz Ruhnau’s hedging strategy made sense?
Although Ruhnau was correct in his assessment that the dollar was too high (“overvalued”), the
position he constructed to manage the position was not really effective. By hedging half the DM 7.6
million exposure, he basically divided the exposure in half, hedging half and leaving half uncovered.
The resulting positions will move opposite in their valuation as the exchange rate moves (in either
direction).
2.
To what degree did he limit the upside and downside exposure of the transaction by hedging one-half
of it? Do you agree with his critics that he was speculating?
Ruhnau did not effectively manage his exchange rate risk. A completely uncovered position would
have no upper or lower limit to its exposure. A position which is one-half covered would still have no
limit to it upside or downside, only half the slope or rate of movement as the totally uncovered
position. A call option on dollars (or put option on marks) would have placed an absolute upper limit
on how much Ruhnau and Lufthansa would have to pay to settle the Boeing purchase.
It is difficult to truly agree with the argument that he was speculating. Ruhnau was indeed trying to
manage or hedge the exposure, but his strategy was definitely flawed. To accuse him of speculating
on the component which was covered with the forward contract is to not understand the concept of
transaction exposure and how a short position in a foreign currency could potentially cause severe
monetary losses or excessive expenses in the event the foreign currency appreciated significantly
before cash settlement.
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3.
Moffett • Fundamentals of Multinational Finance, Second Edition
Is it fair to judge transaction exposure management effectiveness with 20-20 hindsight?
Although most would agree it is not “fair” to judge exposure management effectiveness with perfect
hindsight, it is a common practice in industry. Managerial behavior and results must always be
interpreted on the basis of both decision-making at specific points in time—recognizing the risks and
uncertainties of decisions made about the future—and the eventual results and outcomes of those
decisions. Outcomes cannot be ignored, but management decision-making to protect the firm, its
shareholders and creditors against adverse impacts of exchange rate movements, is a necessary part
of risk management.
A more effective and fair measure of performance is probably to measure outcomes as hedged against
corporate benchmarks which are agreed upon prior to the hedging. Common benchmarks are a full
forward cover outcome, or an average of the full forward and completely uncovered position (which
is indeed what Ruhnau did!).
Chapter 8
Transaction Exposure
Problem 8.1 Lipitor in Indonesia
Evaluating the costs of hedging transaction exposure.
Assumptions
Receivable due in 3 months, in Indonesian rupiah (Rp)
Spot rate (Rp/$)
Expected spot rate in 90 days (Rp/$)
3-month forward rate (Rp/$)
Minimum dollar amount acceptable at settlement
Values
Rp1,650,000,000
9,450
9,400
9,950
$168,000.00
At Spot
$174,603.17
Values
Risk
Assessment
If spot rate in 90 days is same as current
(Rp750,000,000/Rp8,800/$)
$174,603.17
Risky
If spot rate in 90 days is Rp9,400/$
(Rp750,000,000/Rp9,400/$)
$175,531.91
Risky
If spot rate in 90 days is Rp9,800/$
(Rp750,000,000/Rp9,800/$)
$165,829.15
Risky
A/R sold forward 90 days
$165,829.15
Certain
“Cost of cover” is the forward discount on Rp
–20.1%
Alternatives
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
2. Sell Indonesian rupiah forward.
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
The cost of forward cover, 20.1%, is indicative of the “artificial interest rates” used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
forward cover.
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.2 Embraer of Brazil
Advise Embraer on currency exposure.
Assumptions
Receivable due in one year, US dollars
Payable due in one year, US dollars
Spot rate, R$/$
One-year US dollar eurocurrency interest rate
One-year Brazilian govt deposit note
Implied one year forward rate = spot × (1 + iR$)/(1 + i$)
Values
$80,000,000
$20,000,000
3.148
4.00%
14.00%
3.4507
Risk
Values Assessment
Analysis
Net exposure at time of cash settlements:
One year A/R due
One year A/P due
Net exposure
$80,000,000
$(20,000,000)
$60,000,000
Certain
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of
the Brazilian real, 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.
Cash settlement of the net position:
Brazilian reais in one year at current spot rate
R$188,880,000.00
Risky
Brazilian reais in one year at one year forward rate
R$207,041,538.46
Certain
In this case, however, because the real is selling forward at a considerable discount, the net long
position—if sold forward—yields considerably more real than the current spot rate. It should also
be noted, however, that if the real were to fall considerably over the coming year, by remaining
unhedged Embraer would enjoy greater reais returns.
Problem 8.3 Hindustan Lever
Advise Hindustan Lever on its Japanese yen purchase.
Assumptions
180-day account payable, Japanese yen (¥)
Spot rate (¥/$)
Spot rate, rupees/dollar (Rs/$)
Implied (calculated) spot rate (¥/Rs)
180-day forward rate (¥/Rs)
Expected spot rate in 180 days (¥/Rs)
180-day Indian rupee investing rate
180-day Japanese yen investing rate
Currency agent’s exchange rate fee
Hindustan Lever’s cost of capital
Hedging Alternatives
Values
8,500,000
120.60
47.75
2.5257
2.4000
2.6000
8.000%
1.500%
4.850%
12.00%
Values
(120.60/47.75)
Spot
Rate (Rp/$)
Risk
Assessment
1. Remain Uncovered, settling A/P in 180 days at spot rate
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
3,541,666.67
2.4000
Certain
2. Buy Japanese yen forward 180 days
Settlement amount at forward rate (Rs)
139
(Continued)
Transaction Exposure
3,365,464.34
Chapter 8
If spot rate in 180 days is same as current spot
140
3. Money Market Hedge
Principal A/P (¥)
discount factor for yen investing rate for 180 days
Principal needed to meet A/P in 180 days (¥)
8,500,000.00
0.9926
8,436,724.57
Current spot rate (¥/Rs)
Indian rupee, current amount (Rs)
Hindustan Lever’s WACC carry-forwad factor for 180 days
Future value of money market hedge (Rs)
2.5257
3,340,411.26
1.0600
3,540,835.94
Certain
4. Indian Currency Agent Hedge
Principal A/P (¥)
Current spot rate (¥/Rs)
Current A/P (Rs)
8,500,000.00
2.5257
3,365,464.34
Plus agent’s fee (4.850%)
Hindustan’s WACC carry-forwad factor for 180 days on fee
Total future value of agent’s fee (Rs)
163,225.02
1.0600
173,018.52
Total A/P, future value, A/P + fee (Rs)
3,538,482.87
Evaluation of Alternatives
The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.
Certain
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.3 Hindustan Lever (Continued)
Chapter 8
Transaction Exposure
141
Problem 8.4 Mattel Toys
Advise Mattel on its European sales.
Assumptions
90-day A/R (€)
Current spot rate (4/€)
Credit Suisse 90-day forward rate ($/€)
Barclays 90-day forward rate ($/€)
Expected spot rate in 90 days ($/€)
90-day eurodollar interest rate
90-day euro-euro interest rate
Implied 90-day forward rate (calculated, $/€)
90-day eurodollar borrowing rate
90-day euro-euro borrowing rate
Mattel Toys weighted average cost of capital ($)
Values
€30,000,000.00
$1.2186
$1.2170
$1.2210
$1.1800
4.000%
4.400%
$1.2174
5.600%
6.400%
9.600%
Hedging Alternatives
Values
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
Risk
Assessment
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
2. Sell euros forward 90 days
Settlement amount at Credit Suisse forward rate $36,510,000.00
Risky
Settlement amount at Barclays forward rate
3. Money Market Hedge
Principal A/R in euros
discount factor for euro borrowing rate for 90 days
Borrow euros against 90-day A/R
Current spot rate, $/euro
US dollar current value
Mattel’s WACC carry-forward factor for 90 days
$36,630,000.00
Certain
Certain
€30,000,000.00
0.9843 1/(1 + (0.064 × 90/360))
€29,527,559.06
$1.2186
$35,982,283.46
1.0240
1 + (0.0960 × 90/360)
Future value of money market hedge $36,845,858.27
Certain
Evaluation of Alternatives
The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost
of capital as the reinvestment rate (carry-forward rate).
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.5 Tek: Italian account receivable
Hedging foreign exchange risk: a receivable
Assumptions
Account receivable due in 3 months, in euros (€)
Spot rate ($/(€)
3-month forward rate ($/€)
3-month euro interest rate
3-month put option on euros:
Strike rate ($/€)
Premium, percent per year
Tek’s weighted average cost of capital
What are the costs and risk of each alternative?
Values
€4,000,000.00
1.2000
1.2180
4.200%
1.0800
3.400%
9.800%
a)
Value
b)
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
US dollar proceeds of receivable would be $4,872,000.00
Certain;
Locked-in
Chapter 8
Transaction Exposure
143
Problem 8.5 Tek: Italian account receivable (Continued)
3. Buy a put option on euros
Amount of euro receivable €4,000,000.00
Current spot rate ($/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
the option is exercised yielding gross dollars of $4,320,000.00
Less cost of option (premium) plus US$interest on premium $(167,198.40)
Net proceeds of A/R if option is exercised (this is Minimum) $4,152,801.60
Summary of Alternatives
Value
Do Nothing $4,800,000.00
Sell A/R forward $4,872,000.00
Buy Put Option $4,152,801.60
Minimum is
guaranteed;
could be
greater.
Certainty?
Risky
Certain
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 $1.20/€, then Tek might consider purchasing the put option on euros.
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.6 Tek: Japanese account payable
Hedging foreign exchange risk: a payable
Assumptions
Account payable to Japan Sony-Tek, in Japanese yen (¥)
Spot rate (¥/$)
6-month forward rate (¥/$)
6-month yen deposit rate
6-month dollar interest rate
6-month call option on yen:
Strike rate (¥/$)
Premium, percent per year
Tek’s weighted average cost of capital
What are the costs and risk of each alternative?
Values
8,000,000.00
108.20
106.20
1.250%
4.000%
108.00
2.500%
9.800%
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
US dollar cost of settling payable would be
$75,329.57
Very uncertain;
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
US dollar cost of settling payable would be
$73,937.15
Very uncertain;
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
US dollar cost of settling payable would be
$75,329.57
Certain;
Locked-in
Chapter 8
Transaction Exposure
145
Problem 8.6 Tek: Japanese account payable (Continued)
3. Money market hedge—invest funds in yen deposit now
Principal needed at the end of 6-months, yen
Discount factor, 6-months @ yen deposit rate
Yen deposit needed, now
Current spot rate (¥/$)
US dollars needed now, for exchange into yen
Carry-forward rate, 6 months @ Tek’s WACC
US cost of money market hedge at end of 6-months
8,000,000
0.9938
7,950,311
108.20
$73,477.92
1.05
$77,078.33
1/(1 + (0.0125 × 180/360))
1 + (0.0980 × 180/360)
4. Buy a call option on Japanese yen
Amount of yen payable 8,000,000.00
Current spot rate (¥/$)
108.20
Premium on call option, %
2.500%
Cost of call option
$1,848.43
If the spot rate at end of 3-months is greater than strike rate
the option is exercised yielding gross dollars of
Plus cost of option (premium) plus US$interest on premium
Total cost of exercising call option on yen
Summary of Alternatives: Cost of settling A/P
Do Nothing
Buy yen forward
Deposit yen now (money market hedge)
Buy call option on yen
$74,074.07
$1,939.00
$76,013.08
Maximum cost
guaranteed;
could be
less.
Value
$73,937.15
$75,329.57
$77,078.33
$76,013.08
Certainty?
Risky
Certain
Certain
Maximum
c) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view
that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere
below the option strike rate of ¥108/$, 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.
146
Hedging foreign exchange risk of a contract bid
Assumptions
Account receivable of bid, supply & install (British pounds, £)
Spot rate ($/£)
Tek’s weighted average cost of capital
Forward rate ($/£)
British pound investment rate
British pound borrowing rate
Put option on pound:
Strike rate ($/£)
Premium ($/£)
Analysis and Evaluation
Values
£1,500,000
1.8418
9.800%
1-month
1.8368
4.000%
6.500%
4-month
1.8268
4.125%
6.500%
1.85
$0.006
1.85
$0.012
a) Value
b) Certainty
$2,762,700.00
Risky
$2,740,200.00
Risky
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
If the ending spot rate is the same as the 4-month forward rate
It could, however, be much lower.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.7 Tek: British Telecom bidding
2. Sell the pounds forward
Selling 1 million pounds forward at the 4-month forward rate
The primary problem with this is that if Tek does not win the bid,
it has a forward contract to sell pounds which it will not earn.
$2,740,200.00
£1,500,000
0.9788
£1,468,189
1.8418
$2,704,110.93
1.0327
$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
and the 4-months opportunity cost of premium
Total premium expense
$18,000.00
588.00
$18,588.00
$2,756,412.00
1 + (0.098 × 120/360)
Minimum;
Could be More
The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid’s award.
The advantage of the option is if Tek does not win the bid, the option can easily be sold.
Transaction Exposure
Minimum dollars received if put option purchased
1/(1+ (0.065 × 120/360))
Chapter 8
3. Money market hedge—borrow against expected receipts
Expected receipts (£)
Discount factor for 4-months at pound borrowing rate
Proceeds from borrowing, now (£)
Current spot rate ($/£)
Proceeds from borrowing, now ($)
Carry-forward rate, 4 months @ Tek’s WACC
Value in 4 months of money market hedge ($)
Certain Value
If Tek Wins Bid
147
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.8 Tek—Swedish price list
Hedging foreign currency price quotes and potential sales.
Assumptions
Expected sale over 90-day period, Swedish krona (SKr)
Spot rate (SKr/$)
90-day forward rate (SKr/$)
3-month dollar interest rate
3-month krona deposit interest rate
3-month krona borrowing interest rate
3-month put option on krona:
Strike rate (SKr/$)
Premium
Tek’s weighted average cost of capital
Values
5,000,000.00
7.4793
7.4937
4.000%
4.780%
6.500%
Could be more
7.50
2.500%
9.800%
Hedging Alternatives
This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of
sales will occur, and therefore what Tek’s actual long position in Swedish krona will be.
Value
Certainty?
1. Do Nothing—Remain Uncovered.
The ending spot rate at the time of settlement
could be nearly anything.
If the ending spot rate is the same as current spot rate (SKr/$) $668,511.76
Risky
If the ending spot rate is the same as forward (SKr/$)
$667,227.14
Risky
$667,227.14
Certain
2. Sell Swedish krona forward
Sold forward 3-months at forward rate (SKr/$)
However, remember that Tek does not know total sales.
Chapter 8
Transaction Exposure
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 $673,938.79
4. Buy a 3-month put option on Swedish krona
If exercised
Proceeds will be option less premium if exercised (minimum)
Exchange rate if exercised/not exercised (SKr/$)
7.50
Amount of Swedish krona 5,000,000.00
If exercised, it will yield a gross dollar amount of $666,666.67
If not exercised
(random choice)
7.24
5,000,000.00
$690,607.73
Put option premium
Opportunity cost of premium
Total future value of premium
$16,712.79
409.46
$17,122.26
$16,712.79
409.46
$17,122.26
Minimum net dollar proceeds at end of 90 days
(exercised gross amount less future value of premium)
$649,544.41
Minimum
$673,485.48
The money market hedge provides the highest certain US dollar receipts. (This is again a result of the
significant increase in relative value arising from carrying-forward the dollars at Tek’s WACC.)
If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr
would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the
same amount of US dollars as the money market hedge.
149
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.9 Tek: Swiss dividend payable
Hedging an intra-company dividend payment.
Assumptions
Dividend declared, Swiss francs (SFr)
Spot rate (SFr/$)
90-day forward rate (SFr/$)
3-month US dollar interest rate
3-month Swiss franc interest rate
3-month put option on Swiss francs:
Strike rate (SFr/$)
Premium ($/SFr)
Tek’s weighted average cost of capital
Tek’s expected spot rate in 90 days (SFr/$)
Hedging Alternatives
Values
SFr. 5,000,000
1.2462
1.2429
4.000%
3.750%
1.25
$0.015
9.80%
1.22
Value
Certainty?
If the ending spot rate is the same as current spot rate (SFr/$)
$4,012,197.08
Risky
If the ending spot rate is the same as forward (SKr/$)
$4,022,849.79
Risky
1. Do Nothing—Remain Uncovered.
Realistically, the ending spot rate could vary between SFr1 and SFr2 per $.
2. Sell Swiss francs forward
Sold forward 3-months at forward rate (SFr/$)
$4,022,849.79
Certain
Chapter 8
Transaction Exposure
Problem 8.9 Tek: Swiss dividend payable (Continued)
3. Money Market Hedge
Borrow SFr now against future receipt
Principal SFr. 5,000,000
Borrow SFr at SFr interest rate for 90-days
0.9907
SFr proceeds received now via borrowing SFr. 4,953,560
Exchanged into US$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
Principal of payment, SFr SFr. 5,000,000
If exercised, it will yield a gross dollar amount of $4,000,000.00
1.22
SFr. 5,000,000
$4,098,360.66
Put option premium
Opportunity cost of premium
Total future value of premium
$75,000.00
1,837.50
$76,837.50
$75,000.00
1,837.50
$76,837.50
Minimum net dollar proceeds at end of 90 days
(exercised gross amount less future value of premium)
$3,923,162.50
Minimum
$4,021,523.16
Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however,
Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger
SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This
is still not superior to the Money Market Hedge. (The ending spot rate would need to be
SFr1.20/$or stronger to end up superior to the Money Market Hedge.)
151
152
Hedging foreign exchange risk: A/R & forward points
Assumptions
Spot rate, DKr/C$
3-month forward rate, DKr/C$
6-month forward rate, DKr/C$
12-month forward rate, DKr/C$
Northern’s Exposures
A/R due in 3 months, DKr
A/R due in 6 months, DKr
A/R due in 12-months, DKr
Values
4.70
4.71
4.72
4.74
0–90 days
3,000,000
Forward
Discount
–0.85%
–0.85%
–0.84%
91–180 days
> 180 days
2,000,000
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$forward.
Northern Rainwear is receiving foreign currency, DKr, at future dates (“long DKr”).
Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD.
Required Forward Cover for Northern:
0–90 days
91–180 days
> 180 days
A/R due in 3 months, DKr
75%
A/R due in 6 months, DKr
60%
A/R due in 12-months, DKr
50%
DKr Forward Cover
A/R due in 3 months, DKr
2,250,000
A/R due in 6 months, DKr
1,200,000
A/R due in 12-months, DKr
500,000
Expected Canadian dollar value of DKr sold forward
477,707.01
254,237.29
105,485.23
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.10 Northern Rainwear
Chapter 8
Transaction Exposure
Problem 8.11 Vamo Road Industries
Hedging foreign exchange risk: a payable
Assumptions
Construction payment due in six-months (A/P, quetzals)
Present spot rate (quetzals/$)
Six-month forward rate (quetzals/$)
Guatemalan six-month interest rate (per annum)
U.S. dollar six-month interest rate (per annum)
Vamo’s weighted average cost of capital (WACC)
Expected spot rate in six-months (quetzals/$):
Highest expected rate
Expected rate
Lowest expected rate
Values
8,400,000
7.0000
7.1000
14.000%
6.000%
20.000%
a) What realistic alternatives are available to Vamo?
1. Wait six months and make payment at spot rate
Cost
Certainty
Highest expected rate
$1,050,000.00
Risky
Expected rate
$1,150,684.93
Risky
Lowest expected rate
$1,312,500.00
Risky
$1,183,098.59
Certain
7,850,467.29
$1,121,495.33
1.10
$1,233,644.86
Certain
2. Purchase quetzals forward six-months
(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)
Cost in dollars today (quetzals to $at spot rate)
factor to carry dollars forward 180 days (1 + (WACC/2))
Cost in dollars in six-months ($carried forward 180 days )
8.0000
7.3000
6.4000
The second choice, the forward contract, results in the lowest cost alternative among
certain alternatives.
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.12 Worldwide Travel’s acquisition
Hedging foreign exchange risk: a payable
Assumptions
Acquisition price & 3-month A/P, NewTaiwan dollars (T$)
Spot rate (T$/$)
3-month forward rate (T$/$)
3-month Taiwan dollar deposit rate
3-month dollar borrowing rate
3-month call option on T$
Evaluation of Alternatives
Values
7,000,000
33.40
32.40
1.500%
6.500%
not available
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
$216,049.38
Certain
Although this would do nothing to cover the currency risk,
there would be no required payment or borrowing for 3-months.
2. Buy T$forward 3-months
Assured cost of T$at 3-month forward rate
The purchase of a forward contract would not require any cash
up-front, but the Bank of Hawaii would reduce his available credit
line by the amount of the forward. This is a non-cash expense.
3. Money Market Hedge: Exchanging US$for T$now, depositing for 3-months until payment
Acquisition price in T$needed in 3-months
Discounted back 3-months at T$deposit rate
Amount of NT$needed now for deposit
Spot rate, T$/$
US$needed now for exchange
7,000,000
0.9963
6,973,848
33.40
$208,797.85
US$carry-forward rate (3-month dollar borrowing rate)
Carry-forward factor of US$for 3-month period
Total cost in US$of settling A/P in 3-months with
Money Market Hedge
6.500%
1.0163
$212,190.81
Certain
The currency risk is eliminated, but since Matt Morita would have to exchange the money upfront, it requires Matt Morita to increase his debt outstanding for the entire 3 months.
Forward contract hedge is probably the best “acceptable” alternative.
Chapter 8
Transaction Exposure
155
Problem 8.13 Seattle Scientific, Inc.
Costs and benefits of cash versus cover.
Assumptions
Seattle’s 30-day account receivable, Japanese yen
Spot rate, yen/$
30-day forward rate, yen/$
90-day forwrad rate, yen/$
180-day forward rate, yen/$
Yokasa’s WACC
Seattle Scientific’s WACC
Desired discount on purchase price by Yokasa
Values
12,500,000
120.23
119.73
118.78
117.21
8.850%
12.500%
4.500%
Josh Miller 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)
Discount for cash payment up-front (4.500%)
Amount paid in cash net of discount
12,500,000
(562,500)
11,937,500
Current spot rate
Amount received in U.S. dollars by Seattle Scientific
120.23
$99,288.86
2. Not offer any discounts for early payment and cover exposure with forwards
Account receivable (yen)
30-day forward rate
Amount received in cash in dollars, in 30 days
12,500,000
119.73
$104,401.57
Discount factor for 30 days @ Seattle’s WACC
Present value of dollar cash received
0.9897
$103,325.27
Josh Miller should politely decline Yokasa’s offer to pay cash in exchange for cash payment.
156
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.14 Wilmington Chemical Company
Hedging foreign exchange risk: a payable
Assumptions
Shipment of phosphates from Morocco, Moroccan dirhams
Wilmington’s cost of capital (WACC)
Spot exchange rate, dirhams/$
Six-month forward rate, dirhams/$
Options on Moroccan dirhams:
Strike price, dirhams/$
Option premium (percent)
Values
6,000,000
14.000%
10.00
10.40
Call Option
10.00
2.000%
Put Option
10.00
3.000%
United States
6.000%
5.000%
Morocco
8.000%
7.000%
Values
Certainty
1. Remain uncovered, making the dirham payment in six months
at the spot rate in effect at that date
Account payable (dirhams)
Possible spot rate in six months—the current spot rate (dirhams/$)
Cost of settlement in six months (US$)
6,000,000
10.00
$600,000.00
Uncertain.
Account payable (dirhams)
Possible spot rate in six months—forward rate (dirhams/$)
Cost of settlement in six months (US$)
6,000,000
10.40
$576,923.08
Uncertain.
Six-month interest rate for borrowing (per annum)
Six-month interest rate for investing (per annum)
Risk Management Alternatives
Chapter 8
Transaction Exposure
Problem 8.14 Wilmington Chemical Company (Continued)
2. Forward market hedge. Buy dirhams forward six months.
Account payable (dirhams)
Six month forward rate, dirhams/$
Cost of settlement in six months (US$)
6,000,000
10.40
$576,923.08
Certain.
3. Money market hedge. Exchange dollars for dirhams now, invest for six months.
Account payable (dirhams)
6,000,000.00
Discount factor at the dirham investing rate for 6 months
1.035
Dirhams needed now for investing (payable/discount factor)
5,797,101.45
Current spot rate (dirhams/$)
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
$620,289.86
Certain.
4. Call option hedge. (Need to buy dirhams = call on dirhams)
Option principal
Current spot rate, dirhams/$
Premium cost of option
Option premium (principal/spot rate × % pm)
6,000,000.00
10.00
2.000%
$12,000.00
If option exercised, dollar cost at strike price of 10.00 dirhams/$
Plus premium carried forward six months (pm × 1.07, WACC)
Total net cost of call option hedge if exercised
$600,000.00
12,840.000
$612,840.00
Maximum.
The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to
depreciate significantly over the next six months, it may choose the call option.
157
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.15 Dawg-Grip, Inc.
Hedging foreign exchange risk: a payable
Assumptions
Purchase price of Korean manufacturer, in Korean won
Less initial payment, in Korean won
Net settlement needed, in Korean won, in six months
Current spot rate (Won/$)
Six month forward rate (Won/$)
Plasti-Grip’s cost of capital (WACC)
Options on Korean won:
Strike price, won
Option premium (percent)
Values
7,030,000,000
(1,000,000,000)
6,030,000,000
1,200
1,260
25.00%
Call Option
1,200.00
3.000%
Put Option
1,200.00
2.400%
United States
4.000%
6.000%
Korea
16.000%
18.000%
Values
Certainty
1. Remain uncovered, making the won payment in 6 months
at the spot rate in effect at that date
Account payable (won)
Possible spot rate in six months: current spot rate (won/$)
Cost of settlement in six months (US$)
6,030,000,000
1,200
$5,025,000.00
Uncertain.
Account payable (won)
Possible spot rate in six months: forward rate (won/$)
Cost of settlement in six months (US$)
6,030,000,000
1,260
$4,785,714.29
Uncertain.
Six-month investment interest rate (per annum)
Six-month borrowing rate (investment rate + 2%)
Risk Management Alternatives
Chapter 8
Transaction Exposure
Problem 8.15 Dawg-Grip, Inc. (Continued)
2. Forward market hedge. Buy won forward six months
Account payable (won)
Forward rate (won/$)
Cost of settlement in six months (US$)
6,030,000,000
1,260.00
$4,785,714.29
Certain.
3. Money market hedge. Exchange dollars for won now, invest for six months.
Account payable (won)
6,030,000,000
Discount factor at the won interest rate for 6 months
1.080
Won needed now (payable/discount factor) 5,583,333,333.33
Current spot rate (won/$)
1,200.00
US dollars needed now
$4,652,777.78
Carry forward rate for six months (WACC)
1.125
US dollar cost, in six months, of settlement
$5,234,375.00
Certain.
4. Call option hedge. (Need to buy won = call on won)
Option principal
Current spot rate (won/$)
Premium cost of option (%)
Option premium (principal/spot rate × % pm)
If option exercised/not exercised, dollar cost of won
Premium carried forward six months (pm × 1.125, WACC)
Total net cost of call option hedge if exercised
If exercised If not exercised
6,030,000,000
1,200.00
1,307.00
3.000%
$150,750.00
$5,025,000.00
169,593.750
$5,194,593.75
Maximum.
$4,613,618.97
169,593.75
$4,783,212.72
The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes
the ending spot rate will be Won 1307/$or higher, the call option hedge could prove lower cost. This would require the
firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event
their spot rate expectations proved incorrect.
159
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.16 Aqua-Pure
Hedging foreign exchange risk: a receivable
Assumptions
Amount of receivable, Japanese yen
Spot exchange rate at time of sale (yen/$)
Booked value of sale (amount/spot rate)
Days receivable due
Aqua-Pure’s WACC
Competitor borrowing premium, yen
Values
20,000,000
118.255
$169,126.04
90
16.0%
2.0%
Forward rates and premiums
One-month forward rate (yen/$)
Three-month forward rate (yen/$)
One-year forward rate (yen/$)
Forward Rate
117.760
116.830
112.450
Premium
5.04%
4.88%
5.16%
Investment rates, % per annum
1 month
3 months
12 months
United States
4.8750%
4.9375%
5.1875%
Japan
0.09375%
0.09375%
0.31250%
Purchased options
3-month call option on yen
3-month put option on yen
Strike (yen/$)
118.000
118.000
Premium
1.0%
3.0%
Chapter 8
Transaction Exposure
161
Problem 8.16 Aqua-Pure (Continued)
a. Alternative Hedges
Values
Certainty
20,000,000
118.255
$169,126.04
Uncertain.
20,000,000
116.830
$171,188.91
Certain.
1. Remain uncovered.
Account receivable (yen)
Possible spot rate in 90 days (yen/$)
Cash settlement in 90 days (US$)
2. Forward market hedge.
Account receivable (yen)
Forward rate (won/$)
Cash settlement in 90 days (US$)
3. Money market hedge.
Account receivable (yen)
Discount factor for 90 days
Yen proceeds up front
Current spot rate (won/$)
US dollars received now
Carry forward at Aqua-Pure’s WACC
Proceeds in 90 days
4. Put option hedge. (Need to sell yen = put on yen)
Option principal
Current spot rate (won/$)
Premium cost of option (%)
Option pm (principal/spot rate × % pm)
If option exercised, dollar proceeds
Less Pm carried forward 90 days
Net proceeds in 90 days
20,000,000
1.00523 1 + ((0.0009375 + .02) × 90/360)
19,895,858
118.255
$168,245.38
1.0400
1 + (0.16 × 90/360)
$174,975.20
Certain.
20,000,000
118.255
3.000%
$5,073.78
$169,491.53
(5,276.732)
$164,214.79
1.04 carry-forward rate
Minimum.
The put option does not GUARANTEE the company of settling for the booked amount.
The money market and forward hedges do; the money market yielding the higher proceeds.
b) Breakeven rate between the money market and the forward hedge is determined by the
reinvestment rate:
Money market, US$up-front
$168,245.38
Forward contract, US$, end of 90 days
$171,188.91
(1 + x)
101.750%
$168,245 (1 + x) = $171,189
x
1.74954%
For 90 days
Breakeven rate, % per annum
6.998%
162
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.17 Botox Watch Company
Hedging policy
Assumptions
Account recievable in 90 days (€)
Initial spot exchange rate ($/€)
Forward rate, 90 days ($/€)
Expected spot rate in 90 to 120 days ($/€): Case #1
Expected spot rate in 90 to 120 days ($/€): Case #2
Values
1,560,000
$1.2340
$1.2460
$1.2000
$1.2600
If Botox Watch Company ……
Proportion of exposure to be hedged
Total exposure (€)
hedged proportion
Minimum hedge in euros (exposure × min prop)
at the forward rate ($/€)
locking in ($)
Hedged
the Minimum
70%
1,560,000
70%
1,092,000
$1.2460
$1,360,632
Hedged
the Maximum
120%
1,560,000
120%
1,872,000
$1.2460
$2,332,512
Case #1: Ending spot rate
Proportion uncovered (short)
If ending spot rate is ($/€)
Value of uncovered proportion ($)
468,000
$1.2000
$561,600
(312,000)
$1.2000
$(374,400)
Value of covered proportion (from above)
Total net proceeds, covered + uncovered
$1,360,632
$1,922,232
Case #2: Ending spot rate
Proportion uncovered (short)
If ending spot rate is ($/€)
value of uncovered proportion ($)
468,000
$1.2600
$589,680
Value of covered position (from above)
Total net proceeds, covered + uncovered
$1,360,632
$1,950,312
$2,332,512
$1,939,392
$1,943,760
$1,943,760
Benchmark: Full (100%) forward cover
$2,332,512
$1,958,112
(312,000)
$1.2600
$(393,120)
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.
Problem 8.18 Redwall Pump Company
Hedging foreign exchange risk: a receivable
Assumptions
90-day Forward rate, $/euro
180-day Forward rate, $/euro
US Treasury bill rate
Redwall’s borrowing rate, euros, per annum
Redwall’s cost of equity
Options on euros
June maturity options
September maturity options
Values Today is March 1
$1.1060
Exchange Rate
$1.1130
Date
($/euro)
3.600%
February 1
$1.0800
8.000%
March 1
$1.1000
12.000%
Strike ($/euro)
$1.1000
$1.1000
Valuation of Alternative Hedges
Amount of receivable, in euros
Call Option
3.0%
2.6%
Put Option
2.0%
1.2%
June Receivable
€2,000,000
Sept
Receivable
€2,000,000
€2,000,000
$1.1060
$2,212,000
1.03
$2,278,360
€2,000,000
$1.1130
$2,226,000
—
$2,226,000
$4,504,360
Transaction Exposure
Amount of receivable, in euros
Respective forward rates ($/euro)
US dollar proceeds as hedged ($)
Carry forward to Sept 1st at WACC
Total US$proceeds on Sept 1st
Total of both payments
Chapter 8
a. Hedge in the forward market
(Continued)
163
164
b. Hedge in the money market
Amount of receivable, in euros
Discount factor for euro funds, period
Current proceeds from discounting, euros
Current spot rate ($/euro)
Current US dollar proceeds
Carry forward rate for the period
US dollar proceeds on future date
Total of both payments
€2,000,000
1.02
€1,960,784
$1.1000
$2,156,863
1.06
$2,286,275
€2,000,000
1.04
€1,923,077
$1.1000
$2,115,385
1.06
$2,242,308
$4,528,582
Amount of receivable, in euros
Buy put options for maturities (% × spot value)
Carry forward for the period
Premium cost carried forward to Sept 1
€2,000,000
$(44,000)
1.06
$(46,640)
€2,000,000
$(26,400)
1.06
$(27,984)
Gross put option value if exercised
Carried forward 3 months to Sept 1
Gross proceeds, Sept 1
Total net proceeds, after premium deduction, Sept 1
$2,200,000
1.03
$2,266,000
$2,200,000
—
$2,200,000
$4,391,376
Amount of receivable, in euros
Ending spot exchange rate ($/euro)
€2,000,000
???
€2,000,000
???
c. Hedge with options
d. Do nothing (remain uncovered)
The money market hedge provides the highest certain outcome.
If Redwall 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.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.18 Redwall Pump Company (Continued)
Problem 8.19 Pixel’s financial metrics
Transaction exposure life-span and accounting treatment.
Date
Event
February 1
March 1
Price quotation by Metrica
Contract signed for sale
Contract amount, pounds
Product shipped to Grand Met
Product received by Grand Met
Grand Met makes payment
June 1
August 1
September 1
Spot Rate
Forward Rate
Days Forward
of Forward Rate
1.7850
1.7465
£1,000,000
1.7689
1.7840
1.7290
1.7771
1.7381
210
180
1.7602
1.7811
—
90
30
—
Analysis
1 million pounds @ $1.7290/pound
1 million pounds @ $1.7689/pound
$1,729,000
$1,768,900
$(39,900)
b. The vlaue of the foreign exchange gain (loss) will depend upon when Leo 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.
Transaction Exposure
Value as settled
Value as booked
FX gain (loss)
Chapter 8
a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, 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).
(Continued)
165
166
Forward contract purchased on June 1
Value of forward settlement 1 million pounds @ $1.7602/pound
Value as booked
1 million pounds @ $1.7689/pound
FX gain (loss)
$1,760,200
$1,768,900
$(8,700)
A more aggressive alternative is for Leo to purchase the forward contract on the date that the contract was signed, March 1, lockingin Pixel’s US dollar settlement amount a full 90 days earlier in the transaction exposure’s life span.
Forward contract purchased on March 1
Value of forward settlement 1 million pounds @ $1.7381/pound
Value as booked
1 million pounds @ $1.7689/pound
FX gain (loss)
$1,738,100
$1,768,900
$(30,800)
Note that in this case if Leo had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would
have been even greater, although “fully hedged.” The difference is of course the result of the forward rate changing with spot rates
and interest differentials.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.19 Pixel’s financial metrics (Continuted)
Value
3,000,000
1.7620
1.7550
6.000%
8.000%
8.000%
14.000%
1.75
1.500%
12.000%
1.7850
Rate ($/pound)
Proceeds
$1.7620
$1.7550
$1.7850
Rate ($/pound)
$5,286,000.00
$5,265,000.00
$5,355,000.00
Proceeds
$1.7550
$5,265,000.00
Alternative #3: Money Market Hedge
Rate ($/pound)
Trident borrows against the A/R, receiving pounds up-front, exchanging into US$.
Amount of A/R in 90-days, in pounds
Discount factor, pound borrowing rate, for 3-months
Proceeds of borrowing, up-front, in pounds
Exchanged to US$at current spot rate of
$1.7620
US$received against A/R, up-front
US$need to be carried forward for comparison:
Carry-forward rate, WACC for 90-days
Money Market Hedge, US$, at end of 90-days
Proceeds
1.71
1.000%
$5,107,246.38
167
1.0300
$5,260,463.77
(Continued)
Transaction Exposure
3,000,000.00
0.9662
2,898,550.72
Chapter 8
Problem 8.20 Maria Gonzalez and Trident (A)
Assumptions
90-day A/R in pounds
Spot rate, US$per pound
90-day forward rate, US$per pound
3-month U.S. dollar investment rate
3-month U.S. dollar borrowing rate
3-month UK investment interest rate
3-month UK borrowing interest rate
Put options on the British pound: Strike rates, US$/pound
Put option premium
Trident’s WACC
Maria Gonzalez’s expected spot rate in 90-days, US$per pound
Alternative #1: Remain Uncovered
Value of A/R will be (3 million pounds × ending spot rate ($/pound))
If spot rate is the same as current spot rate
If ending spot rate is the same as current forward rate
If ending spot rate is the expected spot rate
Alternative #2: Forward Contract Hedge
Sell the pounds forward 3-months locking in the forward rate
Pound A/R at the forward rate (pounds × forward)
168
Option premium
Notional principal of option (pounds)
Spot rate ($/pound)
Option premium, US$
Carry-forward factor, WACC, for 90-days
Total premium cost, in 90-days
Strike Rate ($/pnd)
1.75
1.500%
3,000,000
1.7620
$79,290.00
1.0300
$81,668.70
Strike Rate ($/pnd)
1.71
1.000%
3,000,000
1.7620
$52,860.00
1.0300
$54,445.80
Proceeds from put option if exercised
Less cost of premium, including time-value
Net proceeds from put options, in 90-days: Minimum
$5,250,000.00
(81,668.70)
$5,168,331.30
$5,130,000.00
(54,445.80)
$5,075,554.20
Ending spot rate needed to be superior to forward:
Proceeds from exchanging pounds for US$spot
Less cost of option (allowed to expire OTM)
Net proceeds from put option, unexercised
$1.7825
$5,347,500.00
(81,668.70)
$5,265,831.30
$1.7732
$5,319,600.00
(54,445.80)
$5,265,154.20
Alternative #4: Put Option Hedges
Analysis: Maria Gonzalez would receive the most certain US$from the forward contract, $5,265,000; the money
market hedge is less attractive as result of the higher borrowing costs in the UK now. The two put options 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 was $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.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.20 Maria Gonzalez and Trident (A) (Continued)
Problem 8.21 Maria Gonzalez and Trident (B)
Construction of Trident’s income statement, with foreign exchange losses and EPS by strategy.
Assumption
1.0560
1.5900
122.43
1.0560
1.5900
122.43
1.0560
1.5900
122.43
1.0250
1.5875
120.85
1.0250
1.5875
120.85
1.0250
1.5875
120.85
1.0660
1.5600
126.00
1.0660
1.5600
126.00
1.0660
1.5600
126.00
—
—
—
—
—
—
1.0480
1.6000
122.50
€2,340,000
£1,780,000
125,000,000
a)
Settled at Forecast
$23,400
$(53,400)
$(28,928)
$(58,928)
€2,340,000
£1,780,000
125,000,000
b)
Settled at Forward
$(72,540)
$(4,450)
$13,349
$(63,641)
€2,340,000
£1,780,000
125,000,000
c)
Forwards on Points
$(45,630)
$6,67
$13,34
$(25,606)
Part c) Positions
Paying points
Paying points
Receiving points
50% Fwd Cover
50% Fwd Cover
100% Fwd Cover
(Continued)
169
Assumption
Transaction Exposure
FX gains (losses) by sale:
Sales in European euros
Sales in British pounds
Sales in Japanese yen
Assumption
Chapter 8
Exchange Rate Assumptions
Spot exchange rates at booking:
US dollars per euro
US dollars per pound
Japanese yen per dollar
90-day forward rates:
US dollars per euro
US dollars per pound
Japanese yen per dollar
Spot rate forecasts:
US dollars per euro
US dollars per pound
Japanese yen per dollar
Settlement spot rates:
US dollars per euro
US dollars per pound
Japanese yen per dollar
Export sales in currency of invoice:
Sales in European euros
Sales in British pounds
Sales in Japanese yen
170
Income Statement (US$)
Sales
Domestic sales
Export sales
Less cost of goods sold
Gross profit
Less G&A expenses
Less depreciation
Foreign exchange gains (losses)
EBIT
Less US corporate taxes
Net income
Shares outstanding
Earnings per share (EPS)
Uncovered
Settled at Forecast
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
100% Forward
Cover
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
Forward Cover
Based on Points
$13,622,232
7,300,000
6,322,232
(8,854,451)
$4,767,781
9%
(1,226,001)
(248,750)
(58,928)
$3,234,102
(1,226,001)
(248,750)
(63,641)
$3,229,389
(1,226,001)
(248,750)
(25,606)
$3,267,424
40%
(1,293,641)
$1,940,461
(1,291,755)
$1,937,633
(1,306,969)
$1,960,454
1,000,000
$1.940
1,000,000
$1.938
1,000,000
$1.960
65%
Trident’s EPS is highest in part c), where it determined its forward cover by whether it would receive or pay the forward points. In part c), for both the
euro and the pound, Dayton is paying the points, and would therefore decide to cover 50% of the exposure with forwards (the yen is receiving the
points, and is 100% covered with forwards). The foreign exchange loss for the pound is smaller in part c) because the pound moved in the company’s
favor. Although the euro moves against the firm, the loss is not as large as what would occur under the forward contract.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 8.21 Maria Gonzalez and Trident (B) (Continued)
Chapter 8
Transaction Exposure
Problem 8.22 Siam Cement
Assumptions
US dollar debt taken out in June 1997
US dollar borrowing rate on debt
Initial spot exchange rate, baht/dollar, June 1997
Average spot exchange rate, baht/dollar, June 1998
Value
$50,000,000
8.400%
25.00
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
Repayment of US dollar debt: Interest
Total repayment
Exchange rate at time of repayment, baht/dollar
Total repayment in Thai baht
Total proceeds from loan, up-front, in Thai baht
Net interest to be paid, in Thai baht
Actual Repayment:
Repayment of US dollar debt: Principal
Repayment of US dollar debt: Interest
Total repayment
Exchange rate at time of repayment, baht/dollar
Total repayment in Thai baht
Less what Siam had EXPECTED or SCHEDULED to be repaid
Amount of foreign exchange loss on debt
$50,000,000
4,200,000
$54,200,000
25.00
1,355,000,000
1,250,000,000
105,000,000
$50,000,000
4,200,000
$54,200,000
42.00
2,276,400,000
(1,355,000,000)
921,400,000
171