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IM-71
CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND
PROBLEMS
QUESTIONS
1. How would you define transaction exposure? How is it different from economic exposure?
Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s
contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates.
Unlike economic exposure, transaction exposure is well-defined and short-term.
2. Discuss and compare hedging transaction exposure using the forward contract vs. money market
instruments. When do the alternative hedging approaches produce the same result?
Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign
currency receivables or payables forward. On the other hand, money market hedge is achieved by
borrowing or lending the present value of foreign currency receivables or payables, thereby creating
offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are
equivalent.
3. Discuss and compare the costs of hedging via the forward contract and the options contract.
Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging,
however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging,
however, may be realized ex post when the hedger regrets his/her hedging decision.
4. What are the advantages of a currency options contract as a hedging tool compared with the forward
contract?
Answer: The main advantage of using options contracts for hedging is that the hedger can decide whether
to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against
ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk
while retaining the upside potential.
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5. Suppose your company has purchased a put option on the German mark to manage exchange exposure
associated with an account receivable denominated in that currency. In this case, your company can be
said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.
Answer: Your company in this case knows in advance that it will receive a certain minimum dollar
amount no matter what might happen to the $/€ exchange rate. Furthermore, if the German mark
appreciates, your company will benefit from the rising euro.
6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply
do not hedge. How would you explain this result?
Answer: There can be many possible reasons for this. First, many firms may feel that they are not really
exposed to exchange risk due to product diversification, diversified markets for their products, etc.
Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders
can diversify exchange risk themselves, rendering corporate risk management unnecessary.
7. Should a firm hedge? Why or why not?
Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to
their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure
better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge
at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it
reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations
by hedging which stabilizes corporate earnings.
8. Using an example, discuss the possible effect of hedging on a firm’s tax obligations.
Answer: One can use an example similar to the one presented in the chapter.
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9. Explain contingent exposure and discuss the advantages of using currency options to manage this type
of currency exposure.
Answer: Companies may encounter a situation where they may or may not face currency exposure. In this
situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they
may or may not receive or have to pay. If companies either hedge using forward contracts or do not hedge
at all, they may face definite currency exposure.
10. Explain cross-hedging and discuss the factors determining its effectiveness.
Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The
effectiveness of cross-hedging would depend on the strength and stability of the relationship between the
two assets.
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PROBLEMS
1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10
million payable in six months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign
exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months.
(a) What is the expected gain/loss from the forward hedging?
(b) If you were the financial manager of Cray Research, would you recommend hedging this euro
receivable? Why or why not?
(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward
exchange rate quoted today. Would you recommend hedging in this case? Why or why not?
Solution: (a) Expected gain($) = 10,000,000(1.10 – 1.05)
= 10,000,000(.05)
= $500,000.
(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by
$500,000 and also eliminate the exchange risk.
(c) Since I eliminate risk without sacrificing dollar receipt, I still would recommend hedging.
2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million
payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is ¥100/$.
The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan.
The management of IBM decided to use the money market hedge to deal with this yen account payable.
(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen
obligation.
(b) Conduct the cash flow analysis of the money market hedge.
Solution: (a). Let’s first compute the PV of ¥250 million, i.e.,
250m/1.0175 = ¥245,700,245.70
So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity
value will be exactly equal to ¥25 million which is the amount of payable.
To buy the above yen amount today, it will cost:
$2,340,002.34 = ¥245,700,245.70/105.
The dollar cost of meeting this yen obligation is $2,340,002.34 as of today.
(b)
___________________________________________________________________
Transaction CF0 CF1
____________________________________________________________________
1. Buy yens spot -$2,340,002.34
with dollars ¥245,700,245.70
2. Invest in Japan - ¥245,700,245.70 ¥250,000,000
3. Pay yens - ¥250,000,000
Net cash flow - $2,340,002.34
____________________________________________________________________
3. You plan to visit Geneva, Switzerland in three months to attend an international business conference.
You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As
of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy
the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF.
Assume that your expected future spot exchange rate is the same as the forward rate. The three-month
interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.
