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Spot rate, ¥/$ ¥111.40/$
30-day forward rate, ¥/$ ¥111.00/$
90-day forward rate, ¥/$ ¥110.40/$
180-day forward rate, ¥/$ ¥109.20/$
Numata's WACC 8.850%
BioTron Medical's WACC 9.200%
Assumptions Values
BioTron's 30-day account receivable, Japanese yen 12,500,000
Spot rate, ¥/$ 111.40
30-day forward rate, ¥/$ 111.00
90-day forward rate, ¥/$ 110.40
180-day forward rate, ¥/$ 109.20
Numata's WACC 8.850%
BioTron Medical's WACC 9.200%
Desired discount on purchase price by Numata 4.500%
Brent Bush should compare two basic alternatives, both of which eliminate the currency risk.
1. Allow the discount and receive payment in Japanese yen in cash
Account recievable (yen) 12,500,000
Discount for cash payment up-front (4.500%) (562,500)
Amount paid in cash net of discount 11,937,500
Current spot rate 111.40
Amount received in U.S. dollars by Seattle Scientific 107,158.89$
2. Not offer any discounts for early payment and cover exposure with forwards
Account receivable (yen) 12,500,000
30-day forward rate 111.00
Amount received in cash in dollars, in 30 days 112,612.61$
Discount factor for 30 days @ Seattle's WACC 0.9924
Present value of dollar cash received 111,755.82$
Brent Bush should politely decline Numata's offer to pay cash in exchange for the requested discount.
Problem 10.1 BioTron Medical, Inc.
How much in U.S. dollars will BioTron Medical receive 1) with the discount and 2) with no discount but fully
covered with a forward contract?
Brent Bush, CFO of a medical device manufacturer, BioTron Medical, Inc., was approached by a Japanese
customer, Numata, with a proposal to pay cash (in yen) for its typical orders of ¥12,500,000 every other month if
it were given a 4.5% discount. Numata's current terms are 30 days with no discounts. Using the following quotes
and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments with
forward contracts. Should Brent Bush accept Numata's proposal?
111
US dollar cost, in six months, of settlement 5,693,193.19$ Certain.
4. Call option hedge. (Need to buy won = call on won)
If exercised If not exercised
Option principal 6,500,000,000
Current spot rate (won/$) 1,110.00 1,300.00
Premium cost of option (%) 3.000%
Option premium (principal/spot rate x % pm) 175,675.68$
If option exercised/not exercised, dollar cost of won 5,416,666.67$ 5,000,000.00$
Premium carried forward six months (pm x 1.125, WACC) 184,459.459 184,459.46
Total net cost of call option hedge if exercised 5,601,126.13$ 5,184,459.46$
Maximum.
The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If, however, the firm believes the
ending spot rate will be a weaker Won, Won1,200/$ or higher, then the call option would be a lower cost alternative. This would require,
however, that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the Won
did not fall to the needed level.
Assumptions Value
US dollar debt taken out in June 1997 50,000,000$
US dollar borrowing rate on debt 8.400%
Initial spot exchange rate, baht/dollar, June 1997 25.00
Average spot exchange rate, baht/dollar, June 1998 42.00
Calculation of Foreign Exhange Loss on Repayment of Loan
At the time the loan was acquired, the scheduled repayment of dollar
and baht amounts would have been as follows:
Scheduled Repayment:
Repayment of US dollar debt: Principal 50,000,000$
Repayment of US dollar debt: Interest 4,200,000
Total repayment 54,200,000$
Exchange rate at time of repayment, baht/dollar 25.00
Total repayment in Thai baht 1,355,000,000
Total proceeds from loan, up-front, in Thai baht 1,250,000,000
Net interest to be paid, in Thai baht 105,000,000
Actual Repayment:
Repayment of US dollar debt: Principal 50,000,000$
Repayment of US dollar debt: Interest 4,200,000
Total repayment 54,200,000$
Exchange rate at time of repayment, baht/dollar 42.00
Total repayment in Thai baht 2,276,400,000
Less what Siam had EXPECTED or SCHEDULED to be repaid (1,355,000,000)
Amount of foreign exchange loss on debt 921,400,000
Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the
Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s,
taking on massive quantities of foreign currency denominated debt (primarily U.S. dollars). When the Thai
baht (B)was devalued from its pegged rate of B25.0/$ in July 1997, Siam’s interest payments alone were
over $900 million on its outstanding dollar debt (with an average interest rate of 8.40% on its U.S. dollar
debt at that time). Assuming Siam Cement took out $50 million in debt in June 1997 at 8.40% interest, and
had to repay it in one year when the spot exchange rate had stabilized at B42.0/$, what was the foreign
exchange loss incurred on the transaction?
Problem 10.3 Siam Cement
Assumptions Values
180-day account payable, Japanese yen (¥) 8,500,000
Spot rate (¥/$) 120.60
Spot rate, rupees/dollar (Rs/$) 47.75
Implied (calculated) spot rate (¥/Rs) 2.5257 (120.60 / 47.75)
180-day forward rate (¥/Rs) 2.4000
Expected spot rate in 180 days (¥/Rs) 2.6000
180-day Indian rupee investing rate 8.000%
180-day Japanese yen investing rate 1.500%
Currency agent's exchange rate fee 4.850%
P & G India's cost of capital 12.00%
Spot Risk
Hedging Alternatives Values Rate (Rp/$) Assessment
1. Remain Uncovered, settling A/P in 180 days at spot rate
If spot rate in 180 days is same as current spot 3,365,464.34 2.5257 Risky
If spot rate in 180 days is same as forward rate 3,541,666.67 2.4000 Risky
If spot rate in 180 days is expected spot rate 3,269,230.77 2.6000 Risky
2. Buy Japanese yen forward 180 days
Settlement amount at forward rate (Rs) 3,541,666.67 2.4000 Certain
3. Money Market Hedge
Principal A/P (¥) 8,500,000.00
discount factor for yen investing rate for 180 days 0.9926
Principal needed to meet A/P in 180 days (¥) 8,436,724.57
Current spot rate (¥/Rs) 2.5257
Indian rupee, current amount (Rs) 3,340,411.26
P&G India's WACC carry-forward factor for 180 days 1.0600
Future value of money market hedge (Rs) 3,540,835.94 Certain
4. Indian Currency Agent Hedge
Principal A/P (¥) 8,500,000.00
Current spot rate (¥/Rs) 2.5257
Current A/P (Rs) 3,365,464.34
Plus agent's fee (4.850%) 163,225.02
P & G India's WACC carry-forwad factor for 180 days on fee 1.0600
Total future value of agent's fee (Rs) 173,018.52
Total A/P, future value, A/P + fee (Rs) 3,538,482.87 Certain
Evaluation of Alternatives
Problem 10.4 P & G India
Proctor and Gamble’s affiliate in India, P & G India, procures much of its toiletries product line from a Japanese company. Because of the
shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge a 8.5
million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen.
Additionally, a common practice in India is for companies like P & G India to work with a currency agent who will, in this case, lock in the
current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging
strategy.
The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.
Assumptions Values At Spot
Receivable due in 3 months, in Indonesian rupiah (Rp) Rp1,650,000,000 $174,603.17
Spot rate (Rp/$) 9,450
Expected spot rate in 90 days (Rp/$) 9,400
3-month forward rate (Rp/$) 9,950
Minimum dollar amount acceptable at settlement $168,000.00
Risk
Alternatives Values Assessment
1. Remain Uncovered.
Settle A/R in 90 days at current spot rate.
If spot rate in 90 days is same as current $174,603.17 Risky
(Rp 1,650,000,000 / Rp 9,450/$)
If spot rate in 90 days is Rp9,400/$ $175,531.91 Risky
(Rp 1,650,000,000 / Rp 9,400/$)
If spot rate in 90 days is Rp9,800/$ $165,829.15 Risky
(Rp 1,650,000,000 / Rp 9,950/$)
2. Sell Indonesian rupiah forward.
A/R sold forward 90 days $165,829.15 Certain
"Cost of cover" is the forward discount on Rp -20.1%
Analysis
The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period,
any variety of economic or political or social events could lead to an upward bounce in the exchange rate,
reducing the dollar proceeds at settlement to an unacceptable level.
Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin.
Problem 10.5 Elan Pharmaceuticals
Elan Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its
cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million
Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000.
Although not a big sale by company standards, company policy dictates that sales must be settled for at least a
minimum gross margin, in this case, a cash settlement of $168,000. The current 90-day forward rate is Rp9,950/$.
Although this rate appeared unattractive, Elan had to contact several major banks before even finding a forward
quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold
relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and
make a hedging recommendation.
The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial
institutions while pricing derivatives in emerging, illiquid, and volatile markets.
In the end, Elan will have to decide whether making the sale into this specific market is worth breaking a
company policy on minimum proceeds (forward cover) or taking significant currency risk by not using
a forward cover.
Assumptions Values
Receivable due in one year, US dollars $80,000,000
Payable due in one year, US dollars $20,000,000
Spot rate, reais per dollar (R$/$) 1.8240
One-year US dollar eurocurrency interest rate 4.00%
One-year Brazilian govt deposit note 10.50%
Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) 1.9380
Risk
Analysis Values Assessment
Net exposure at time of cash settlements:
One year A/R due $80,000,000
One year A/P due ($20,000,000)
Net exposure $60,000,000 Certain
Cash settlement of the net position:
Brazilian reais in one year at current spot rate R$ 109,440,000.00 Risky
Brazilian reais in one year at one year forward rate R$ 116,280,000.00 Certain
Problem 10.6 Embraer of Brazil
This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian reais, that
it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most
Brazilian companies is considered a very good thing.
Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other).
Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100
people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one
year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs
– it must pay foreign suppliers $20 million for inputs one year from now (but they will be delivering the sub-components
throughout the year). The current spot rate on the Brazilian real (R$) is R$1.8240/$, but it has been steadily appreciating
against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and are considered expensive.
Citibank Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a
forward off the current 4.00% U.S. dollar eurocurrency rate and the 10.50% Brazilian government deposit note. Advise
Embraer on its currency exposure.
In this case, however, because the reais is selling forward at a considerable discount, the net long position -- if sold forward --
yields considerably more reais than the current spot rate. It should also be noted, however, that if the reais were to fall
considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.
Spot exchange rate: ¥118.255 ¥118.255/$ (closing mid-rates)
One-month forward rate: ¥117.760 5.04%
Three-month forward: ¥116.830 4.88%
One-year forward: ¥112.450 5.16%
Money Rates United States Japan Differential
One month 4.8750% 0.09375% 4.78125%
Three months 4.9375% 0.09375% 4.84375%
Twelve months 5.1875% 0.31250% 4.87500%
Three-month options from Kyushu Bank:
* Call option on ¥20,000,000 at exercise price of
¥118.00/$: a 1% premium.
* Put option on ¥20,000,000, at exercise price of
¥118.00/$: a 3% premium.
a) What are the costs and benefits of alternative hedges? Which would you recommend, and why?
b) What is the breakeven reinvestment rate when comparing forward and money market alternatives?
Assumptions Values
Amount of receivable, Japanese yen (¥)20,000,000
Spot exchange rate at time of sale (¥/$) 118.255
Booked value of sale (amount/spot rate) $169,126.04
Days receivable due 90
Krystal's WACC 16.0%
Competitor borrowing premium, yen (¥)2.0%
Forward rates and premiums Forward Rate Premium
One-month forward rate (¥/$) 117.760 5.04%
Three-month forward rate (¥/$) 116.830 4.88%
One-year forward rate (¥/$) 112.450 5.16%
Investment rates, % per annum United States Japan
1 month 4.8750% 0.09375%
3 months 4.9375% 0.09375%
12 months 5.1875% 0.31250%
Purchased options Strike (yen/$) Premium
3-month call option on yen 118.000 1.0%
3-month put option on yen 118.000 3.0%
a. Alternative Hedges Values Certainty
1. Remain uncovered.
Account receivable (yen) 20,000,000
Possible spot rate in 90 days (yen/$) 118.255
Cash settlement in 90 days (US$) $169,126.04 Uncertain.
2. Forward market hedge.
Account receivable (yen) 20,000,000
Forward rate (won/$) 116.830
Cash settlement in 90 days (US$) $171,188.91 Certain.
Problem 10.7 Krystal
Krystal is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 11th the company sold a system to the City of
Nagasaki, Japan, for installation in Nagasaki’s famous Glover Gardens (where Puccini’s Madame Butterfly waited for the return of Lt. Pinkerton.) The sale was
priced in yen at ¥20,000,000, with payment due in three months.
Additional information: Krystal’s Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese
money rate. Krystal's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable.
Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot ¥118.255/$, for
example, is a mid-point range. On April 11, the spot yen traded in London from ¥118.30/$ to ¥117.550/$.
3. Money market hedge.
Account receivable (yen) 20,000,000
Discount factor for 90 days 1.00523 1 + ((.0009375 + .02) x 90/360)
Yen proceeds up front 19,895,858
Current spot rate (won/$) 118.255
US dollars received now $168,245.38
Carry forward at Krystal's WACC 1.0400 1 + (.16 x 90/360)
Proceeds in 90 days $174,975.20 Certain.
4. Put option hedge. (Need to sell yen = put on yen)
Option principal 20,000,000
Current spot rate (won/$) 118.255
Premium cost of option (%) 3.000%
Option pm (principal/spot rate x % pm) $5,073.78
If option exercised, dollar proceeds $169,491.53
Less Pm carried forward 90 days (5,276.732) 1.04 carry-forward rate
Net proceeds in 90 days $164,214.79 Minimum.
The put option does not GUARANTEE the company of settling for the booked amount.
The money market and forward hedges do; the money market yielding the higher proceeds.
b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate:
Money market, US$ up-front $168,245.38
Forward contract, US$, end of 90 days $171,188.91
(1 + x) 101.750% $168,245.38 (1+x) = $171,188.91
x 1.74954% For 90 days
Breakeven rate, % per annum 6.9982%
Caribou River's Manadatory Forward Cover 0-90 days 91-180 days > 180 days
Paying the points forward 75% 60% 50%
Receiving the points forward 100% 90% 50%
Forward
Assumptions Values Discount
Spot rate, DKr/C$ 4.70
3-month forward rate, DKr/C$ 4.71 -0.85%
6-month forward rate, DKr/C$ 4.72 -0.85%
12-month forward rate, DKr/C$ 4.74 -0.84%
South Face's Exposures 0-90 days 91-180 days > 180 days
A/R due in 3 months, DKr 3,000,000
A/R due in 6 months, DKr 2,000,000
A/R due in 12-months, DKr 1,000,000
Analysis & Exposure Management
The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward.
Caribou River is receiving foreign currency, DKr, at future dates ("long DKr").
Caribou River is therefore expecting to PAY THE POINTS FORWARD.
Required Forward Cover for Compass Rose: 0-90 days 91-180 days > 180 days
A/R due in 3 months, DKr 75%
A/R due in 6 months, DKr 60%
A/R due in 12-months, DKr 50%
DKr Forward Cover
A/R due in 3 months, DKr 2,250,000
A/R due in 6 months, DKr 1,200,000
A/R due in 12-months, DKr 500,000
Expected Canadian dollar value of DKr sold forward 477,707.01 254,237.29 105,485.23
Problem 10.8 Caribou River
Caribou River, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date
of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory
forward contract cover formula:
Caribou expects to receive multiple payments in Danish kroner over the next year. DKr 3,000,000 is due in 90 days; DKr
2,000,000 is due in 180 days; and DKr 1,000,000 is due in one year. Using the following spot and forward exchange rates, what
would be the amount of forward cover required by company policy by period?
Spot rate (T$/$) 33.40
3-month forward rate (T$/$) 32.40
3-month Taiwan dollar deposit rate 1.500%
3-month dollar borrowing rate 6.500%
3-month call option on T$ not available
Assumptions Values
Acquisition price & 3-month A/P, NewTaiwan dollars (T$) 7,000,000
Spot rate (T$/$) 33.40
3-month forward rate (T$/$) 32.40
3-month Taiwan dollar deposit rate 1.500%
3-month dollar borrowing rate 6.500%
3-month call option on T$ not available
Thomas Carson's credit line with Bank of Hawaii 200,000$
Evaluation of Alternatives Cost Certainty
1. Do Nothing -- Wait 3 months and buy T$ spot
If spot rate is the same as current spot rate 209,580.84$ Risky
If spot rate is the same as 3-month forward rate 216,049.38$ Risky
Although this would do nothing to cover the currency risk,
there would be no required payment or borrowing for 3 -months.
2. Buy T$ forward 3-months
Assured cost of T$ at 3-month forward rate 216,049.38$ Certain
The purchase of a forward contract would not require any cash
up-front, but the Bank of Hawaii would reduce his available credit
line by the amount of the forward. This is a non-cash expense.
3. Money Market Hedge: Exchanging US$ for T$ now, depositing for 3-months until payment
Problem 10.9 Pupule Travel
Pupule Travel, a Honolulu, Hawaii-based 100% privately owned travel company has signed an agreement to acquire a 50%
ownership share of Taichung Travel, a Taiwan-based privately owned travel agency specializing in servicing inbound
customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (T$ 7,000,000) payable in
cash in 3 months.
Thomas Carson, Pupule Travel’s owner, believes the Taiwan dollar will either remain stable or decline a little over the next 3
months. At the present spot rate of T$35/$, the amount of cash required is only $200,000 but even this relatively modest
amount will need to be borrowed personally by Thomas Carson. Taiwanese interest-bearing deposits by non-residents are
regulated by the government, and are currently set at 1.5% per year. He has a credit line with Bank of Hawaii for $200,000
with a current borrowing interest rate of 8% per year. He does not believe that he can calculate a credible weighted average
cost of capital since he has no stock outstanding and his competitors are all also privately held. Since the acquisition would
use up all his available credit, he wonders if he should hedge this transaction exposure. He has quotes from Bank of Hawaii
shown in the table below.
Analyze the costs and risks of each alternative, and then make a recommendation as to which alternative Thomas Carson
should choose.
Acquisition price in T$ needed in 3-months 7,000,000
Discounted back 3-months at T$ deposit rate 0.9963
Amount of NT$ needed now for deposit 6,973,848
Spot rate, T$/$ 33.40
US$ needed now for exchange 208,797.85$
US$ carry-forward rate (3-month dollar borrowing rate) 6.500% Certain
Carry-forward factor of US$ for 3-month period 1.0163
Total cost in US$ of settling A/P in 3-months with 212,190.81$
Money Market Hedge
Discussion.
This is a difficult decision. The forward contract appears to be the preferable choice, protecting him against an appreciating
T$, and creating a certain cash purchase payment. The problem, however, will be whether the Bank of Hawaii will allow him
to purchase a forward for the full $216,049.38, which is slightly above his credit line currently in-place. If his relatonship is
good with the bank, they most likely would increase his line sufficiently to allow the forward contract.
The currency risk is eliminated, but since Thomas Carson would have to exchange the money up-front, it would require him
to borrow the money, increasing his debt outstanding for the entire 3 months.
