CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE
ANSWERS & 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
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
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
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
5. Suppose your company has purchased a put option on the euro 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
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
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,
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
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
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?
(d) Suppose now that the future spot exchange rate is forecast to be $1.17/€. Would you
recommend hedging? Why or why not?
Solution:
(a) Expected gain($) = 10,000,000(1.10 – 1.05)
(b) I would recommend hedging because Cray Research can increase the expected dollar
(c) Since Cray Research can eliminate risk without sacrificing dollar receipt, I still would
(d) Now, hedging via forward contract involves an expected loss: -$700,000 = 10,000,000 (1.10
2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250
million payable in three months. Currently, the spot exchange rate is ¥105/$ 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.,
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.
(b)
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Transaction CF0 CF1
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1. Buy yens spot -$2,340,002.34
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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.
(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option
on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a
forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option
market hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange
rate under both the options and forward market hedges.
Solution:
(a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 =
$250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price,
(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x,
(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option,
4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be
billed €20 million which is payable in one year. The current spot exchange rate is $1.05/€ and
the one-year forward rate is $1.10/€. The annual interest rate is 6.0% in the U.S. and 5.0% in
France. Boeing is concerned with the volatile exchange rate between the dollar and the euro
and would like to hedge exchange exposure.
(a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or
borrow euros from Credit Lyonnaise against the euro receivable. Which alternative would you
recommend? Why?
(b) Other things being equal, at what forward exchange rate would Boeing be indifferent
between the two hedging methods?
Solution:
(a) In the case of forward hedge, the future dollar proceeds will be (20,000,000)(1.10) =
$22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of
its euro receivable, i.e., 20,000,000/1.05 =€19,047,619. Then the firm should exchange this
(b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be:
5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the
$ Cost
Options hedge
Forward hedge
$3,453.75
$3,150
00.57
9
0.64
(strike price)
$/SF
$253.75
(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to
buy up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?
(b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss
client will choose to use for payment? What is the value of this free option for the Swiss client?
(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?
Solution:
(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the
(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive
6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC
owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per
(a) Compute the future dollar costs of meeting this obligation using the money market hedge
and the forward hedges.
(b) Assuming that the forward exchange rate is the best predictor of the future spot rate,
compute the expected future dollar cost of meeting this obligation when the option hedge is
used.
(c) At what future spot rate do you think PCC may be indifferent between the option and forward
hedge?
Solution:
(a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the
(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be
$70,000(1.08) = $75,600.
(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when
the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate.
7. Consider a U.S.-based company that exports goods to Switzerland. The U.S. Company
expects to receive payment on a shipment of goods in three months. Because the payment will
be in Swiss francs, the U.S. Company wants to hedge against a decline in the value of the
Swiss franc over the next three months. The U.S. risk-free rate is 2 percent, and the Swiss risk-
free rate is 5 percent. Assume that interest rates are expected to remain fixed over the next six
months. The current spot rate is $0.5974
a. Indicate whether the U.S. Company should use a long or short forward contract to hedge
currency risk.
b. Calculate the no-arbitrage price at which the U.S. Company could enter into a forward
contract that expires in three months.
c. It is now 30 days since the U.S. Company entered into the forward contract. The spot rate is
$0.55. Interest rates are the same as before. Calculate the value of the U.S. Company’s
forward position.
Solution:
a. The risk to the U.S. company is that the value of the Swiss franc will decline and it will
b. S0 = $0.5974
