978-1337269964 Chapter 11 Solution Manual Part 1

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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 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?

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