978-1337269964 Chapter 11 Solution Manual Part 3

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Your firm in the U.S. expects to need 1 million pounds in one year to pay for imports. You can use

any one of the following strategies to deal with the exchange rate risk:

a. unhedged strategy

b. money market hedge

c. call option hedge

Estimate the dollar cash flows you will need as a result of using each strategy. If the estimate for a

particular strategy involves a probability distribution, show the distribution. Which hedge is optimal?

ANSWER:

Unhedged strategy:

Possible spot

rate in one year Probability Cost of payables

$1.7496 80.00% $1,496,600

$1.8756 20.00% $1,875,600

Money market hedge:

Call option hedge

Possible spot rate

in one year Probability

Cost of hedging

£1,000,000 (including

the option premium)

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Managing Transaction Exposure  2

39. Forecasting Cash Flows and Hedging Decision. Virginia Co. has a subsidiary in Hong Kong

and in Thailand. Assume that the Hong Kong dollar is pegged at $.13 per Hong Kong dollar and it

will remain pegged. The Thai baht fluctuates against the dollar, and is presently worth $.03. Virginia

Co. expects that during this year, the U.S. inflation rate will be 2%, the Thailand inflation rate will be

11%, while the Hong Kong inflation rate will be 3%. Virginia Co. expects that purchasing power

parity will hold for any exchange rate that is not fixed (pegged). The parent of Virginia Co. will

receive 10 million Thai baht and 10 million Hong Kong dollars at the end of one year from its

subsidiaries.

a. Determine the expected amount of dollars to be received by the U.S. parent from the Thai

subsidiary in one year when the baht receivables are converted to U.S. dollars.

b. The Hong Kong subsidiary will send HK$1 million to make a payment for supplies to the Thai

subsidiary. Determine the expected amount of baht that will be received by the Thai subsidiary

when the Hong Kong dollar receivables are converted to Thai baht.

c. Assume that interest rate parity exists. Also assume that the real one-year interest rate in the U.S.

is 1.0%, while the real interest rate in Thailand is 3.0%. Determine the expected amount of dollars

to be received by the U.S. parent if it uses a one-year forward contract today to hedge the

receivables of 10 million baht that will arrive in one year.

ANSWER:

40. Hedging Decision. Indiana Company expects to receive 5 million euros in one year from exports.

It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar

cash flows received as a result of using the following strategies:

a. unhedged strategy

b. money market hedge

c. option hedge

The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Company uses the

forward rate as a predictor of the future spot rate. The annual interest rate in the U.S. is 8% versus an

annual interest rate of 5% in the eurozone. Put options on euros are available with an exercise price of

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Transaction Exposure  3

$1.11, an expiration date of one year from today, and a premium of $.06 per unit. Estimate the dollar

cash flows it will receive as a result of using each strategy. Which hedge is optimal?

ANSWER:

Calculation of Forward Rate

Spot Rate $1.10

Remain Unhedged

Money Market Hedge

Put Option Hedge

41. Overhedging. Denver Co. is about to order supplies from Canada that are denominated in

Canadian dollars (C$). It has no other transactions in Canada, and will not have any other transactions

in the future. The supplies will arrive in one year and payment is due at that time. There is only one

supplier in Canada. Denver submits an order for 3 loads of supplies, which will be priced at C$3

million. Denver Co. purchases C$3 million one year forward, since it anticipates that the Canadian

dollar will appreciate substantially over the year. The existing spot rate is $.62, while the one-year

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Managing Transaction Exposure  4

forward rate is $.64. The supplier is not sure if it will be able to provide the full order, so it only

guarantees Denver Co. that it will ship one load of supplies, and in this case, the supplies will be

priced at C$1 million. Denver Co. will not know whether it will receive one load or three loads until

the end of the year.

Determine Denver’s total cash outflows in U.S. dollars under the scenario that the Canadian supplier

only provides one load of supplies, and that the spot rate of the Canadian dollar at the end of one year

is $.59. Show your work.

ANSWER:

42. Long-term Hedging With Forward Contracts. Tampa Co. will build airplanes and export them

to Mexico for delivery in 3 years. The total payment to be received in 3 years for these exports is 900

million pesos. Today the peso’s spot rate is $.10. The annual U.S. interest rate is 4%, regardless of the

debt maturity. The annual Mexican interest rate is 9% regardless of the debt maturity. Tampa plans to

hedge its exposure with a forward contract that it will arrange today. Assume that interest rate parity

exists. Determine the dollar amount that Tampa will receive in 3 years.

ANSWER:

43. Timing the Hedge. Red River Co. (a U.S. firm) purchases imports that have a price of 400,000

Singapore dollars and it has to pay for the imports in 90 days. It will use a 90-day forward contract to

cover its payables. Assume that interest rate parity exists. This morning, the spot rate of the Singapore

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Managing Transaction Exposure  5

dollar was $.50. At noon, the Federal Reserve reduced U.S. interest rates, while there was no change

in interest rates in Singapore. The Fed’s actions immediately increased the degree of uncertainty

surrounding the value of the Singapore dollar over the next three months. The Singapore dollar’s spot

rate remained at $.50 throughout the day. Assume that the U.S. and Singapore interest rates were the

same as of this morning. Also assume that the international Fisher effect holds. If Red River Co.

purchased a currency call option contract at the money this morning to hedge its exposure, would you

expect that its total U.S. dollar cash outflows be MORE THAN, LESS THAN, or THE SAME AS the

total U.S. dollar cash outflows if it had negotiated a forward contract this morning? Explain.

44. Hedging With Forward Versus Option Contracts. Assume that interest parity exists. Today, the

one-year interest rate in Canada is the same as the one-year interest rate in the U.S. Utah Co. uses the

forward rate to forecast the future spot rate of the Canadian dollar that will exist in one year. It needs

to purchase Canadian dollars in one year. Will the expected cost of its payables be lower if it hedges

its payables with a one-year forward contract on Canadian dollars or a one-year at-the-money call

option contract on Canadian dollars? Explain.

45. Hedging With a Bullspread. (See the chapter appendix.) Evar Imports Inc. buys chocolate from

Switzerland and resells it in the U.S. It just purchased chocolate invoiced at SF62,500. Payment for

the invoice is due in 30 days. Assume that the current exchange rate of the Swiss franc is $.74. Also

assume that three call options for the franc are available. The first option has a strike price of $.74 and

a premium of $.03; the second option has a strike price of $.77 and a premium of $.01; the third

option has a strike price of $.80 and a premium of $.006. Evar Imports is concerned about a modest

appreciation in the Swiss franc.

a. Describe how Evar Imports could construct a bullspread using the first two options. What is the

cost of this hedge? When is this hedge most effective? When is it least effective?

b. Describe how Evar Imports could construct a bullspread using the first option and the third

option. What is the cost of this hedge? When is this hedge most effective? When is it least

effective?

c. Given your answers to parts (a) and (b), what is the tradeoff involved in constructing a bullspread

using call options with a higher exercise price?

ANSWER:

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Transaction Exposure  6

46. Hedging with a Bearspread. (See the chapter appendix.) Marson Inc. has some customers in Canada

and frequently receives payments denominated in Canadian dollars (C$). The current spot rate for the

Canadian dollar is $.75. Two call options on Canadian dollars are available. The first option has an

exercise price of $.72 and a premium of $.03. The second option has an exercise price of $.74 and a

premium of $.01. Marson Inc. would like to use a bearspread to hedge a receivable position of

C$50,000, which is due in one month. Marson is concerned that the Canadian dollar may depreciate

to $.73 in one month.

a. Describe how Marson Inc. could use a bearspread to hedge its position.

b. Assume the spot rate of the Canadian dollar in one month is $.73. Was the hedge effective?

ANSWER:

47. Hedging with Straddles. (See the chapter appendix.) Brooks, Inc. imports wood from Morocco. The

Moroccan exporter invoices in Moroccan dirham. The current exchange rate of the dirham is $.10.

Brooks just purchased wood for 2 million dirham and should pay for the wood in three months. It is

also possible that Brooks will receive 4 million dirham in three months from the sale of refinished

wood in Morocco. Brooks is currently in negotiations with a Moroccan importer about the refinished

wood. If the negotiations are successful, Brooks will receive 4 million dirham in three months, for a

net cash inflow of 2 million dirham. The following option information is available:

Call option premium on Moroccan dirham = $.003

Put option premium on Moroccan dirham = $.002

Call and put option strike price = $.098

One option contract represents 500,000 dirham.

a. Describe how Brooks could use a straddle to hedge its possible positions in dirham.

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Managing Transaction Exposure  7

b. Consider three scenarios. In the first scenario, the dirham’s spot rate at option expiration is equal

to the exercise price of $.098. In the second scenario, the dirham depreciates to $.08. In the third

scenario, the dirham appreciates to $.11. For each scenario, consider both the case when the

negotiations are successful and the case when the negotiations are not successful. Assess the

effectiveness of the long straddle in each of these situations by comparing it to a strategy of using

long call options to hedge.

ANSWER:

$.002]) = $186,000

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Managing Transaction Exposure  8

Net Cash Flow = –2 million Dirham

Dirham value = $.11 in three

months

* Brooks converts dollars to

dirham by exercising its call

options.

$.098) + (2 million × [$.003

+ $.002]) = $206,000

48. Hedging with Straddles versus Strangles. (See the chapter appendix.) Refer to the previous

problem. Assume that Brooks believes the cost of a long straddle is too high. However, call options

on with an exercise price of $.105 and a premium of $.002, and put options with an exercise price of

$.09 and a premium of $.001 are also available on Moroccan dirham. Describe how Brooks could use

a long strangle to hedge its possible dirham positions. What is the tradeoff involved in using a long

strangle versus a long straddle to hedge the positions?

ANSWER: Brooks could construct a long strangle in dirham by buying four call options and buying

four put options with different exercise prices. Due to the relationship between the exercise price and

49. Comparison of Hedging Techniques. You own a U.S. exporting firm and will receive 10 million

Swiss francs in one year. Assume that interest parity exists. Assume zero transactions costs. Today,

the one-year interest rate in the U.S. is 7%, and the one-year interest rate in Switzerland is 9%. You

believe that today’s spot rate of the Swiss franc (which is $.85) is the best predictor of the spot rate

one year from now. You consider these alternatives:

*hedge with one-year forward contract,

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Managing Transaction Exposure  9

*hedge with a money market hedge,

*hedge with at-the-money put options on Swiss francs with a one-year expiration date, or

*remain unhedged.

Which alternative will generate the highest expected amount of dollars? If multiple alternatives are

tied for generating the highest expected amount of dollars, list each of them.

50. PPP and Hedging with Call Options. Visor Inc. (a U.S. firm) has agreed to purchase supplies from

Argentina and will need 1 million Argentine pesos in one year. Interest rate parity presently exists.

The annual interest rate in Argentina is 19%. The annual interest rate in the U.S. is 6%. You expect

that annual inflation will be about 11% in Argentina and 4% in the U.S. The spot rate of the Argentine

peso is $.30. Call options on pesos are available with a one-year expiration date, an exercise price of

$.29, and a premium of $0.03 per unit. Determine the expected amount of dollars that you will pay

from hedging with call options (including the premium paid for the options) if you expect that the

spot rate of the peso will change over the next year based on purchasing power parity (PPP).

51. Long-term Forward Contracts. Assume that interest rate parity exists. The annualized interest rate

is presently 5% in the U.S. for any term to maturity, and is 13% in Mexico for any term to maturity.

Dokar Co. (a U.S. firm) has an agreement in which it will develop and export software to Mexico’s

government two years from now, and will receive 20 million Mexican pesos in two years. The spot

rate of the peso is $.10. Dokar uses a 2-year forward contract to hedge its receivables in two years.

How many dollars will Dokar Co. receive in two years? Show your work.

ANSWER:

Country Two – Year Compounded Return

U.S. (1.05)2 – 1 = 10.25%

52. Money Market Versus Put Option Hedge. Narto Co. (a U.S. firm) exports to Switzerland and

expects to receive 500,000 Swiss francs in one year. The one-year U.S. interest rate is 5% when

investing funds and 7% when borrowing funds. The one-year Swiss interest rate is 9% when investing

funds, and 11% when borrowing funds. The spot rate of the Swiss franc is $.80. Narto expects that the

spot rate of the Swiss franc will be $.75 in one year. There is a put option available on Swiss francs

with an exercise price of $.79 and a premium of $.02.

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Managing Transaction Exposure  10

a. Determine the amount of dollars that Narto Co. will receive at the end of one year if it

implements a money market hedge.

b. Determine the amount of dollars that Narto Co. expects to receive at the end of one year (after

accounting for the option premium) if it implements a put option hedge.

ANSWER:

53. Forward Versus Option Hedge. Assume that interest parity exists. Today, the one-year interest rate

in Japan is the same as the one-year interest rate in the U.S. You use the international Fisher effect

when forecasting how exchange rates will change over the next year. You will receive Japanese yen in

one year. You can hedge receivables with a one-year forward contract on Japanese yen or a one-year

at-the-money put option contract on Japanese yen. If you use a forward hedge, will your expected

dollar cash flows in one year be higher than, lower than, or the same as if you had used put options?

Explain.

ANSWER: Because the two countries have equal one-year interest rates, there is no expected change

54. Long-term Hedging. Rebel Co. (a U.S. firm) has a contract with the government of Spain and will

receive payments of 10,000 euros in exchange for consulting services at the end of each of the next

10 years. The annualized interest rate in the U.S. is 6% regardless of the term to maturity. The

annualized interest rate for the euro is 6% regardless of the term to maturity. Assume that you expect

that the interest rates for the U.S. and for the euro will be the same at any future time, regardless of

the term to maturity. Assume that interest rate parity exists. Rebel considers two alternative strategies:

Strategy (1) – It can use forward hedging one year in advance of the receivables, so that at the end of

each year, it creates a new one-year forward hedge for the receivables,

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