Exam 10: Transaction Exposure

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 euro 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 10.2. If CVT chooses to hedge its transaction exposure in the forward market, it will ________ euro 3,000,000 forward at a rate of ________.

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. If the exchange rate changes to $1.52/£ the U.S. firm will realize a ________ of ________.

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

The stages in the life of a transaction exposure can be broken into three distinct time periods. The first time period is the time between quoting a price and reaching an actual sale agreement or contract. The next time period is the time lag between taking an order and actually filling or delivering it. Finally, the time it takes to get paid after delivering the product. In order, these stages of transaction exposure may be identified as:

Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses are not cash losses and therefore, are not tax deductible.

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.

________ exposure deals with cash flows that result from existing contractual obligations.

A forward hedge involves a put or call option contract and a source of funds to fulfill that contract.

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

Does foreign currency exchange hedging both reduce risk and increase expected value? Explain, and list several arguments in favor of currency risk management and several against.

________ 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.

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

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.

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 euro 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 10.2. 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.)

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 euro 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 10.2. If CVT chooses NOT to hedge their euro payable, the amount they pay in six months will be:

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

Like a forward market hedge, a money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement.

Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should ________ the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should ________.

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

Hedging can be advantageous to shareholders because management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm value through selective hedging.