Exam 10: Transaction Exposure

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

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:

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

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 10.1.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.

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:

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

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 10.1.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.)

Which of the following is cited as a good reason for NOT hedging currency exposures?

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

The various hedging alternatives explored (the forward,money market,and purchase option hedges)only work to protect the value of the exposed asset at the time of maturity.

Hedging,or reducing risk,is the same as adding value or return to the firm.

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

The objective of currency hedging is to eliminate the change in the value of the exposed asset or cash flow from a change in exchange rates.

________ are transactions for which there are,at present,no contracts or agreements between parties.

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 $1.58/£ the U.S.firm will realize a ________ of ________.

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.

Which of the following is NOT cited as a good reason for hedging currency exposures?

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

The commonly used 100% forward contract cover is a symmetric hedge.

When there is a full forward cover with the spot rate equal to the forward rate all of the following are true EXCEPT: