978-1337269964 Chapter 11 Solution Manual Part 1

subject Type Homework Help
subject Pages 8
subject Words 3818
subject Authors Jeff Madura

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POINT/COUNTER-POINT:
Should an MNC Risk Overhedging?
POINT: Yes. MNCs have some “unanticipated” transactions that occur without any advance notice. They
should attempt to forecast the net cash flows in each currency due to unanticipated transactions based on
the previous net cash flows for that currency in a previous period. Even though it would be impossible to
forecast the volume of these unanticipated transactions per day, it may be possible to forecast the volume
on a monthly basis. For example, if an MNC has net cash flows between 3,000,000 and 4,000,000
Philippine pesos every month, it may presume that it will receive at least 3,000,000 pesos in each of the
next few months unless conditions change. Thus, it can hedge a position of 3,000,0000 in pesos by selling
that amount of pesos forward or buying put options on that amount of pesos. Any amount of net cash flows
beyond 3,000,000 pesos will not be hedged, but at least the MNC was able to hedge the minimum expected
net cash flows.
COUNTER-POINT: No. MNCs should not hedge unanticipated transactions. When they overhedge the
expected net cash flows in a foreign currency, they are still exposed to exchange rate risk. If they sell more
currency as a result of forward contracts than their net cash flows, they will be adversely affected by an
increase in the value of the currency. Their initial reasons for hedging were to protect against the weakness
of the currency, but the overhedging described here would cause a shift in their exposure. Overhedging does
not insulate an MNC against exchange rate risk. It just changes the means by which the MNC is exposed.
WHO IS CORRECT? Use the Internet to learn more about this issue. Offer your own opinion on this issue.
ANSWER: If the MNC is confident that it will receive net cash flows in a currency that will likely
depreciate, it should hedge at least the minimum amount of cash flows to be received. If it overhedges, and
the currency’s spot rate declines below the forward rate that was negotiated at the time of the hedge, the
MNC may even benefit from the overhedged position. The MNC should try to avoid overhedging the net
cash flows of a currency that it would expect to strengthen. It may be better off by hedging a smaller
amount or not hedging at all.
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.
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.
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.
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Managing Transaction Exposure 2
4. Net Transaction Exposure. Why should an MNC identify net exposure before hedging?
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.
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.
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
$.49. Develop a table showing a feasibility analysis for hedging. That is, determine the possible differences
between the costs of hedging versus no hedging. What is the probability that hedging will be more costly to
the firm than not hedging? Determine the expected value of the additional cost of hedging.
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Managing Transaction Exposure 3
ANSWER:
Possible Spot Rate
of New Zealand
Dollar Probability
Nominal Cost of
Hedging 100,000
NZ$
Amount of U.S.
Dollars Needed to
Buy 100,000 NZ$ if
Firm Remains
Unhedged
Real Cost of
Hedging
8. Benefits of Hedging. If hedging is expected to be more costly than not hedging, why would a firm even
consider hedging?
ANSWER: Firms often prefer knowing what their future cash flows will be as opposed to the
uncertainty involved with an open position in a foreign currency.
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?
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?
11. Hedging Payables. Assume the following information:
90-day U.S. interest rate = 4%
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Managing Transaction Exposure 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.
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?
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?
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Managing Transaction Exposure 5
15. Long-term Hedging. How can a firm hedge long-term currency positions? Elaborate on each method.
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?
17. Cross-Hedging. Explain how a firm can use cross-hedging to reduce transaction exposure.
18. Currency Diversification. Explain how a firm can use currency diversification to reduce transaction
exposure.
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:
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Managing Transaction Exposure 6
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%
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 Australian dollar
strengthened consistently? What does this imply about the forward rate as an unbiased predictor of the
future spot rate? Explain.
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.
22. Real Cost of Hedging. Would Montana Co.’s real cost of hedging Japanese yen payables have been
positive, negative, or about zero on average over a period in which the yen weakened consistently?
Explain.
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.
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.
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Managing Transaction Exposure 7
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. Explain
how a British firm can use the forward market to hedge periodic purchases of Japanese goods
denominated in yen.
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.
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
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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 Wedcos 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?
.
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