Exam 10: Transaction Exposure

A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£, the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. The U.S. firm is at risk today of a loss if:

A ________ hedge refers to an offsetting operating cash flow such as a payable arising from the conduct of business.

Many MNE s manage foreign exchange exposure centrally, thus gains or losses are always matched with the country of origin.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. The cost of a put option to CVT would be:

According to the authors, firms that employ proportional hedges increase the percentage of forward-cover as the maturity of the exposure lengthens.

When attempting to manage an account payable denominated in a foreign currency, the firm's only choice is to remain unhedged.

The structure of a money market hedge is similar to a forward hedge. The difference is the cost of the money market hedge is determined by the differential interest rates, while the forward hedge is a function of the forward rates quotation.

Hedging transaction exposure with option contracts allows the firm to benefit if exchange rates are favorable but protects the firm if exchange rates turn unfavorable.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. CVT chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be:

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. If CVT chooses to hedge its transaction exposure in the forward market, it will ________ €3,000,000 forward at a rate of ________.

With a perfect hedge, there is no uncovered exposure remaining.

A hedge constructed using puts foreign currency options would be symmetric.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. If CVT locks in the forward hedge at $1.22/euro, and the spot rate when the transaction was recorded on the books was $1.25/euro, this will result in a "foreign exchange accounting transaction ________ of ________.

Although rarely acknowledged by the firms themselves, selective hedging is essentially speculation.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. What is the cost of a call option hedge for CVT's euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm's cost of capital as the appropriate interest rate for calculating future values.)

There is considerable question among investors and managers about whether hedging is a good and necessary tool.

Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally LESS risk averse than are shareholders.

Instruction 10.1: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six-month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro -Refer to Instruction 10.1. CVT would be ________ by an amount equal to ________ with a forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had been correct.

As a generalized rule, only realized foreign exchange losses are deductible for tax purposes.

________ exposure is the potential for accounting-derived changes in owner's equity to occur because of the need to translate foreign currency financial statements into a single reporting currency.