Answers to End of Chapter Questions
1. Hedging in General. Explain the relationship between this chapter on hedging and the
previous chapter on measuring exposure.
ANSWER: The previous chapter explains how to measure exposure, which is necessary before an
2. Money Market Hedge on Receivables. Assume that Stevens Point Co. has net receivables of
100,000 Singapore dollars in 90 days. The spot rate of the S$ is $.50, and the Singapore interest rate
is 2% over 90 days. Suggest how the U.S. firm could implement a money market hedge. Be precise.
ANSWER: The firm could borrow the amount of Singapore dollars so that the 100,000 Singapore
3. Money Market Hedge on Payables. Assume that Hampshire Co. has net payables of 200,000
Mexican pesos in 180 days. The Mexican interest rate is 7% over 180 days, and the spot rate of the
Mexican peso is $.10. Suggest how the U.S. firm could implement a money market hedge. Be
precise.
ANSWER: If the firm deposited MXP186,916 (computed as MXP200,000/1.07) into a Mexican
4. Net Transaction Exposure. Why should an MNC identify net exposure before hedging?
ANSWER: An MNC can reduce the amount of cash flow that it needs to hedge when identifying net
5. Hedging with Futures. Explain how a U.S. corporation could hedge net receivables in euros with
futures contracts. Explain how a U.S. corporation could hedge net payables in Japanese yen with
futures contracts.
ANSWER: The U.S. corporation could agree to a futures contract to sell euros at a specified date in
6. Hedging with Forward Contracts. Explain how a U.S. corporation could hedge net receivables in
Malaysian ringgit with a forward contract.
Explain how a U.S. corporation could hedge payables in Canadian dollars with a forward contract.
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Managing Transaction Exposure 2
ANSWER: The U.S. corporation could sell ringgit forward using a forward contract. This is
7. Real Cost of Hedging Payables. Assume that Loras Corp. imported goods from New Zealand and
needs 100,000 New Zealand dollars 180 days from now. It is trying to determine whether to hedge
this position. Loras has developed the following probability distribution for the New Zealand dollar:
Possible Value of
New Zealand Dollar in 180 Days Probability
$.40 5%
.45 10%
.48 30%
.50 30%
.53 20%
.55 5%
The 180-day forward rate of the New Zealand dollar is $.52. The spot rate of the New Zealand dollar
is $.49. Develop a table showing a feasibility analysis for hedging. That is, determine the possible
differences between the costs of hedging versus no hedging. What is the probability that hedging will
be more costly to the firm than not hedging? Determine the expected value of the additional cost of
hedging.
ANSWER:
Possible Spot Rate
of New Zealand
Dollar Probability
Nominal Cost of
Hedging 100,000
NZ$
Amount of U.S.
Dollars Needed to
Buy 100,000 NZ$ if
Firm Remains
Unhedged
Real Cost of
Hedging
$.40 5% $52,000 $40,000 $12,000
ANSWER: There is a 75% probability that hedging will be more costly than no hedge.
8. Benefits of Hedging. If hedging is expected to be more costly than not hedging, why would a firm
even consider hedging?
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Managing Transaction Exposure 3
ANSWER: Firms often prefer knowing what their future cash flows will be as opposed to the
9. Real Cost of Hedging Payables. Assume that Suffolk Co. negotiated a forward contract to purchase
200,000 British pounds in 90 days. The 90-day forward rate was $1.40 per British pound. The
pounds to be purchased were to be used to purchase British supplies. On the day the pounds were
delivered in accordance with the forward contract, the spot rate of the British pound was $1.44. What
was the real cost of hedging the payables for this U.S. firm?
ANSWER: The U.S. dollars paid when hedging = $1.40(200,000) = $280,000. The dollars paid if
10. Hedging Decision. Kayla Co. imports products from Mexico, and it will make payment in pesos
in 90 days. Interest rate parity holds. The prevailing interest rate in Mexico is very high, which
reflects the high expected inflation there. Kayla expects that the Mexican peso will depreciate over
the next 90 days. Yet, it plans to hedge its payables with a 90-day forward contract. Why may Kayla
believe that it will pay a smaller amount of dollars when hedging than if it remains unhedged?
ANSWER: Since Mexico presently has a very high interest rate, the forward rate of the peso would
11. Hedging Payables. Assume the following information:
90-day U.S. interest rate = 4%
90-day Malaysian interest rate = 3%
90-day forward rate of Malaysian ringgit = $.400
Spot rate of Malaysian ringgit = $.404
Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It
wishes to hedge this payables position. Would it be better off using a forward hedge or a money
market hedge? Substantiate your answer with estimated costs for each type of hedge.
ANSWER: If the firm uses the forward hedge, it will pay out 300,000($.400) = $120,000 in 90 days.
If the firm uses a money market hedge, it will invest (300,000/1.03) = 291,262 ringgit now in a
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Managing Transaction Exposure 4
12. Hedging Decision on Receivables. Assume the following information:
180-day U.S. interest rate = 8%
180-day British interest rate = 9%
180-day forward rate of British pound = $1.50
Spot rate of British pound = $1.48
Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would
it be better off using a forward hedge or a money market hedge? Substantiate your answer with
estimated revenue for each type of hedge.
ANSWER: If the firm uses a forward hedge, it will receive 400,000($1.50) = $600,000 in 180 days.
13. Currency Options. Relate the use of currency options to hedging net payables and receivables. That
is, when should currency puts be purchased, and when should currency calls be purchased? Why
would Cleveland, Inc., consider hedging net payables or net receivables with currency options rather
than forward contracts? What are the disadvantages of hedging with currency options as opposed to
forward contracts?
ANSWER: Currency call options should be purchased to hedge net payables. Currency put options
should be purchased to hedge net receivables.
14. Currency Options. Can Brooklyn Co. determine whether currency options will be more or less
expensive than a forward hedge when considering both hedging techniques to cover net payables in
euros? Why or why not?
ANSWER: No. The amount paid out when using a forward contract is known with certainty.
15. Long-term Hedging. How can a firm hedge long-term currency positions? Elaborate on each
method.
ANSWER: Long-term forward contracts are available to cover positions of five years or longer in
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Managing Transaction Exposure 5
16. Leading and Lagging. Under what conditions would Zona Co.’s subsidiary consider using a
“leading” strategy to reduce transaction exposure? Under what conditions would Zona Co.’s
subsidiary consider using a “lagging” strategy to reduce transaction exposure?
ANSWER: If a subsidiary expected its currency to depreciate against an invoice currency on goods it
17. Cross-Hedging. Explain how a firm can use cross-hedging to reduce transaction exposure.
ANSWER: If a firm cannot hedge a specific currency, it can use a forward contract on a currency
that is highly correlated with the currency of concern.
18. Currency Diversification. Explain how a firm can use currency diversification to reduce transaction
exposure.
ANSWER: If a firm has net inflows in a variety of currencies that are not highly correlated with each
19. Hedging With Put Options. As treasurer of Tucson Corp. (a U.S. exporter to New Zealand), you
must decide how to hedge (if at all) future receivables of 250,000 New Zealand dollars 90 days from
now. Put options are available for a premium of $.03 per unit and an exercise price of $.49 per New
Zealand dollar. The forecasted spot rate of the NZ$ in 90 days follows:
Future Spot Rate Probability
$.44 30%
.40 50
.38 20
Given that you hedge your position with options, create a probability distribution for U.S. dollars to
be received in 90 days.
ANSWER:
Possible
Spot Rate
Put Option
Premium
Exercise
Option?
Amount per
Unit Received
Accounting
for Premium
Total Amount
Received for
NZ$250,000 Probability
$.44 $.03 Yes $.46 $115,000 30%
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Managing Transaction Exposure 6
20. Forward Hedge. Would Oregon Co.’s real cost of hedging Australian dollar payables every 90 days
have been positive, negative, or about zero on average over a period in which the dollar weakened
consistently? What does this imply about the forward rate as an unbiased predictor of the future spot
rate? Explain.
ANSWER: The nominal cost when hedging Australian dollar payables would have been below the
nominal cost of payables on an unhedged basis during the weak dollar period, because the Australian
21. Implications of IRP for Hedging. If interest rate parity exists, would a forward hedge be more
favorable, the same as, or less favorable than a money market hedge on euro payables? Explain.
ANSWER: It would be equally favorable (assuming no transactions costs). If IRP exists, the forward
22. Real Cost of Hedging. Would Montana Co.’s real cost of hedging Japanese yen receivables have
been positive, negative, or about zero on average over a period in which the dollar weakened
consistently? Explain.
ANSWER: During the weak dollar period, the yen appreciated substantially against the dollar. Thus,
23. Forward versus Options Hedge on Payables. If you are a U.S. importer of Mexican goods and you
believe that today’s forward rate of the peso is a very accurate estimate of the future spot rate, do you
think Mexican peso call options would be a more appropriate hedge than the forward hedge?
Explain.
ANSWER: If the forward rate is close to or exceeds today’s spot rate, the forward hedge would be
24.Forward versus Options Hedge on Receivables. You are an exporter of goods to the United
Kingdom, and you believe that today’s forward rate of the British pound substantially underestimates
the future spot rate. Company policy requires you to hedge your British pound receivables in some
way. Would a forward hedge or a put option hedge be more appropriate? Explain.
ANSWER: A put option would be preferable because it gives you the flexibility to exchange pounds
25. Forward Hedging. Explain how a Malaysian firm can use the forward market to hedge periodic
purchases of U.S. goods denominated in U.S. dollars. Explain how a French firm can use forward
contracts to hedge periodic sales of goods sold to the United States that are invoiced in dollars.
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Managing Transaction Exposure 7
Explain how a British firm can use the forward market to hedge periodic purchases of Japanese goods
denominated in yen.
ANSWER: A Malaysian firm can purchase dollars forward with ringgit, which locks in the exchange
rate at which it trades its ringgit for dollars.
26. Continuous Hedging. Cornell Co. purchases computer chips denominated in euros on a monthly
basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. firm negotiates a three-month
forward contract three months before the next order will arrive. In other words, Cornell is always
covered for the next three monthly shipments. Because Cornell consistently hedges in this manner, it
is not concerned with exchange rate movements. Is Cornell insulated from exchange rate
movements? Explain.
ANSWER: No! Cornell is exposed to exchange rate risk over time because the forward rate changes
27. Hedging Payables with Currency Options. Malibu, Inc., is a U.S. company that imports British
goods. It plans to use call options to hedge payables of 100,000 pounds in 90 days. Three call
options are available that have an expiration date 90 days from now. Fill in the number of dollars
needed to pay for the payables (including the option premium paid) for each option available under
each possible scenario.
Spot Rate
of Pound Exercise Price Exercise Price Exercise Price
90 Days = $1.74; = $1.76; = $1.79;
Scenario from Now Premium = $.06 Premium = $.05 Premium = $.03
1 $1.65
2 1.70
3 1.75
4 1.80
5 1.85
If each of the five scenarios had an equal probability of occurrence, which option would you choose?
Explain.
ANSWER:
Spot Rate
of Pound Exercise Price Exercise Price Exercise Price
90 Days = $1.74; = $1.76; = $1.79;
Scenario from Now Premium = $.06 Premium = $.05 Premium = $.03
1 $1.65 $171,000 $170,000 $168,000
2 1.70 176,000 175,000 173,000
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Managing Transaction Exposure 8
28. Forward Hedging. Wedco Technology of New Jersey exports plastics products to Europe. Wedco
decided to price its exports in dollars. Telematics International, Inc. (of Florida), exports computer
network systems to the United Kingdom (denominated in British pounds) and other countries.
Telematics decided to use hedging techniques such as forward contracts to hedge its exposure.
a. Does Wedco’s strategy of pricing its materials for European customers in dollars avoid economic
exposure? Explain.
ANSWER: Wedco avoids transaction exposure but not economic exposure. If the euro weakens
b. Explain why the earnings of Telematics International, Inc., were affected by changes in the value
of the pound. Why might Telematics leave its exposure unhedged sometimes?
ANSWER: Telematics International, Inc. has sales to European customers, which are denominated in
29. The Long-term Hedge Dilemma. St. Louis Inc., which relies on exporting, denominates its exports
in pesos and receives pesos every month. It expects the peso to weaken over time. St. Louis
recognizes the limitation of monthly hedging. It also recognizes that it could remove its transaction
exposure by denominating the exports in dollars but that it is still would be subject to economic
exposure. The long-term hedging techniques are limited and the firm does not know how many pesos
it will receive in the future, so it would have difficulty even if a long-term hedging method was
available. How can this business realistically deal with this dilemma to reduce its exposure over the
long-term?
ANSWER: If it expects that the weakness of the peso over time is attributed to high inflation in
If it is unable to increase its price due to competitive pressure, it should consider moving some of its
30. Long-term Hedging. Since Obisbo Inc. conducts much business in Japan, it is likely to have cash
flows in yen that will periodically be remitted by its Japanese subsidiary to the U.S. parent. What are
the limitations of hedging these remittances one year in advance over each of the next 20 years?
What are the limitations of creating a hedge today that will hedge these remittances over each of the
next 20 years?
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Managing Transaction Exposure 9
ANSWER: If Obisbo Inc. hedges one year in advance, the forward rate negotiated at the beginning of
each year will be based on the spot rate of the yen (and the difference between the Japanese interest
rate and U.S. interest rate) at the beginning of that year. Thus, the forward rate at which the hedge
31. Hedging during a Crisis. Describe how a crisis in Asia could reduce the cash flows of a U.S. firm
that exports products (denominated in U.S. dollars) to Asian countries. How could a U.S. firm that
exported products (denominated in U.S. dollars) to Asia and anticipates an Asian crisis before it began
insulate itself from any currency effects while continuing to export to Asia?
ANSWER: The weakness of the Asian currencies would cause the Asian importers to reduce their
It might have invoiced the exports in the Asian currencies so that the Asian customers would not be
Advanced Questions
32. Comparison of Techniques for Hedging Receivables.
a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of
the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62.
Carbondale created a probability distribution for the future spot rate in one year as follows:
Future Spot Rate Probability
$.61 20%
.63 50
.67 30
Assume that one-year put options on Singapore dollars are available, with an exercise price of
$.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available
with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money
market rates:
U.S. Singapore
Deposit rate 8% 5%
Borrowing rate 9 6
Given this information, determine whether a forward hedge, money market hedge, or a currency
options hedge would be most appropriate. Then compare the most appropriate hedge to an
unhedged strategy, and decide whether Carbondale should hedge its receivables position.
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Managing Transaction Exposure 10
ANSWER:
Forward hedge
Sell S$500,000 × $.62 = $310,000
Put option hedge (Exercise price = $.63; premium = $.04)
Possible Spot
Rate
Option
Premium per
Unit Exercise
Amount
Received per
Unit (also
accounting
for premium)
Total Amount
Received for
S$500,000 Probability
$.61 $.04 Yes $.59 $295,000 20%
Unhedged Strategy
Possible Spot Rate
Total Amount Received for
S$500,000 Probability
b. Assume that Baton Rouge, Inc. expects to need S$1 million in one year. Using any relevant
information in part (a) of this question, determine whether a forward hedge, a money market
hedge, or a currency options hedge would be most appropriate. Then, compare the most
appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its
payables position.
ANSWER:
Forward hedge
Purchase S$1,000,000 one year forward:
S$1,000,000 × $.62 = $620,000
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Managing Transaction Exposure 11
Amount Paid Total
Option per Unit Amount
Possible Premium Exercise (including Paid for
Spot Rate per Unit Option? the premium) S$1,000,000 Probability
$.61 $.03 Yes $.63 $630,000 20%
Unhedged Strategy
Total
Possible Amount Paid
Spot Rate for S$500,000 Probability
$.61 $610,000 20%
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