Strategy (2) – It can establish a hedge TODAY for ALL future receivables (a one-year forward hedge
for receivables in one year, a two-year forward hedge for receivables in two years, and so on).
a. Assume that the euro depreciates consistently over the next 10 years. Will strategy 1 result in
higher, lower, or the same cash flows for Rebel Co. as strategy 2?
b. Assume that the euro appreciates consistently over the next 10 years. Will strategy 1 result in
higher, lower, or the same cash flows for Rebel Co. as strategy 2?
ANSWER:
55. Long-term Hedging. San Fran Co. imports products. It will pay 5 million Swiss francs for
imports in one year. Mateo Co. will also pay 5 million Swiss francs for imports in one year. San Fran
Co. and Mateo Co. will also need to pay 5 million Swiss francs for imports arriving in 2 years.
Today, Mateo Co. uses a one-year forward contract to hedge its payables in one year. A year from
today, it will use a one-year forward contract to hedge the payables that it must pay two years from
today.
Today, San Fran Co. uses a one-year forward contract to hedge its payables due in one year. Today, it
also uses a two-year forward contract to hedge its payables in two years.
Assume that interest rate parity exists and it will continue to exist in the future. You expect that the
Swiss franc will consistently depreciate over the next two years.
Switzerland and the U.S. have similar interest rates, regardless of their maturity, and they will
continue to be the same in the future. Will the total expected dollar cash outflows that San Fran Co.
will pay for its payables be higher than, lower than, or the same as the total expected dollar cash
outflows that Mateo Co. will pay? Explain.
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Managing Transaction Exposure 2
56. Comparison of Hedging Techniques. Today, the spot rate of the euro is $1.20. The one-year forward
rate is $1.16. A one-year call option on euros exists with a premium of $.04 per unit and an exercise
price of $1.17. You think the spot rate is the best forecast of future spot rates. You will need to pay 10
million euros in one year. Determine whether a money market hedge or a call option hedge would be
more appropriate to hedge your payables.
ANSWER: Money market hedge: Invest in euros today so that you have enough to pay 10 million
57. IRP, PPP, and the Hedging Decision. The one-year U.S. interest rate is presently higher than the
Japanese interest rate. Assume a real rate of interest of zero percent in each country. Assume that
interest rate parity exists. You believe in purchasing power parity (PPP). You have receivables of 10
million Japanese yen that you will definitely receive in one year. Should you hedge? Briefly explain.
ANSWER: Since the real rate of interest is zero in each country, the expected rate of inflation is
equal to the actual interest rate. You should hedge because the expected future spot rate according to
58. Cross-Hedging Strategy. Assume that the country of Dreeland has a currency (called the dree) that
tends to move in tandem with the Chile peso and is expected to continue to move in tandem with the
Chilean peso in the future. Indianapolis Co., a U.S. firm, has a large amount of receivables in the
dree. It expects that the dree will depreciate against the dollar over time. There are no derivatives
available on the dree. Indianapolis Co. considers the following strategies to reduce its exchange rate
risk: (a) use a money market hedge in which it converts dollars into dree and maintains a deposit in
the dree for one year, (b) use a forward contract to purchase Chilean pesos forward, (c) sell a put
option hedge on Chilean pesos, (d) purchase a call option on Chilean pesos, and (e) use a forward
contract in which it sells Chilean pesos forward. Which strategy is most appropriate?
59. Estimating the Hedged Cost of Payables. Grady Co. is a manufacturer of hockey equipment in
Chicago, and will need 3 million Swiss francs (SF) in one year to pay for imported supplies. The U.S.
one-year interest rate is 2% while Switzerland’s one-year interest rate is 7%. The spot rate of the SF is
$.90. The one-year forward rate of the SF is $.88. A one-year call option on SF exists with an exercise
price of $.90 and a premium of $.03 per unit. As the treasurer of Grady Co., you think the spot rate of
the SF is the best forecast of the future spot rate of the SF.
a. If you use a money market hedge, determine the amount of dollars that you will pay for the
payables.
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Managing Transaction Exposure 3
b. If you use a call option hedge, determine the expected amount of dollars that you will pay for the
payables (account for the option premium within your estimate).
ANSWER:
CRITICAL THINKING
Currency Options Versus Forward Contracts Write a short essay briefly summarizing the advantages
and disadvantages of currency options as compared to forward contracts when hedging payables. Explain
the conditions (regarding your expectations of the future exchange rate and the uncertainty surrounding the
future exchange rate) that might cause you to use currency options instead of forward contracts if you were
exposed to payables. Do you think you would use currency options or forward contracts more frequently?
ANSWER:
Solution to Continuing Case Problem: Blades, Inc.
1. Using a spreadsheet, compare the hedging alternatives for the Thai baht with a scenario under which
Blades remains unhedged. Do you think Blades should hedge or remain unhedged? If Blades should
hedge, which hedge is most appropriate?
Calculation of Net Baht Paid or Received in 90 Days:
Baht-denominated inflow:
Pairs sold 45,000
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Managing Transaction Exposure 4
Money Market Hedge:
Remain Unhedged:
Total Dollars Received
Possible Spot Rate in 90 Days ($) from Converting Baht
0.0200 3,054,600
2. Using a spreadsheet, compare the hedging alternatives for the British pound receivables with a
scenario under which Blades remains unhedged. Do you think Blades should hedge or remain
unhedged? Which hedge is the most appropriate for Blades?
ANSWER: (See spreadsheet attached.) Based on the analysis, it appears that Blades should hedge its
Calculation of Pounds Received in 90 Days:
Forward Hedge:
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Managing Transaction Exposure 5
× Forward rate of pound 1.4900
= Dollars to be received in 90 days 5,960,000.00
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Managing Transaction Exposure 6
Money Market Hedge:
Borrow pounds, convert to $, invest $, use receivables to pay off loan in 90
days:
Amount in pounds borrowed (4,000,000/1.02) 3,921,568.63
Dollars received from converting pounds (3,921,568.63 × $1.50) 5,882,352.94
Dollars accumulated after 90 days (5,882,352.94 × 1.021) 6,005,882.35
Put Option Hedge:
Purchase put option:
Total Dollars Total Dollars
Premium Received per Received from
Possible Spot per Unit Unit (after Converting
Rate in 90 Paid for Exercise accounting for 4,000,000
Days ($) Option ($) Option? the premium) Pounds Probability
$1.45 $0.02 Y $1.45 $5,800,000 5%
Remain Unhedged:
Possible Spot Total Dollars
Rate in 90 Received from
Days ($) Converting Pounds Probability
$1.45 $5,800,000 5%
1.47 5,880,000 20%
1.48 5,920,000 30%
1.49 5,960,000 25%
1.50 6,000,000 15%
1.52 6,080,000 5%
3. In general, do you think it is easier for Blades to hedge its inflows or its outflows denominated in
foreign currencies? Why?
ANSWER: In general, it is easier for Blades to hedge its inflows denominated in foreign currencies.
4. Would any of the hedges you compared in question 2 for the British pounds to be received in 90 days
require Blades to overhedge? Given Blades’ exporting arrangements, do you think it is subject to
overhedging with a money market hedge?
ANSWER: In this case, none of the hedges would require Blades, Inc. to overhedge. Usually, the put
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Managing Transaction Exposure 7
5. Could Blades modify the timing of the Thai imports in order to reduce its transaction exposure? What
is the tradeoff of such a modification?
6. Could Blades modify its payment practices for the Thai imports in order to reduce its transaction
exposure? What is the tradeoff of such a modification?
7. Given Blades’ exporting agreements, are there any long-term hedging techniques Blades could benefit
from? For this question only, assume that Blades incurs all of its costs in the United States.
Solution to Supplemental Case: Blackhawk Company
This case uses actual data to show how inaccurate forecasts can be.
a. Using the regression model in which FSR is the dependent variable and FR is the independent
variable, the slope coefficient is about .857 and the standard error of the coefficient is .0825.
Therefore, the t-statistic in testing for a bias is:
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Managing Transaction Exposure 8
t = .857 – 1
.0825
–1.733
b. There appears to be a bias, in that the use of the forward rate resulted in negative forecast errors
(overestimation) over 7 of the first 9 quarters and then positive forecast errors (under-estimation) over
7 of the next 11 quarters.
c. The average absolute forecast error when using the forward rate is .02963.
d. Using the regression model in which FSR is the dependent variable and SR is the independent
variable, the slope coefficient is about .8635 and the standard error of the coefficient is about .081.
Therefore, the t-statistic in testing for a bias is:
t = .8635 – 1
.081
–1.685
Using a .05 level of significance, the bias is not significant.
e. There appears to be a bias, in that the use of the spot rate resulted in negative forecast errors
(overestimation) over the first 9 quarters and then positive forecast errors (under-estimation) over 7 of
the next 11 quarters.
f. The average absolute forecast error when using the spot rate is .029815. The forward rate was
slightly better, based on a lower absolute forecast error.
g. Using regression analysis, b0 = .791 and b1 = 4.333. It should be mentioned that the forecast based on
regression analysis is prone to error, as the inflation differential did not explain much of the variation
in PNZ$ over the 20 quarters. Since DIFF is assumed to be 2%, then the forecast of PNZ$ using the
regression coefficients is:
h. The probability distribution for FSR is:
Probability FSR
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Managing Transaction Exposure 9
i. The probability distribution for payments if Blackhawk does not hedge is:
$ Amount
Probability Needed
40% $516,000
40% $470,240
20% $471,200
j. The probability distribution for the real cost of hedging is determined below:
$ Amount $ Amount
Needed if Needed if Real Cost
Probability Hedged Unhedged of Hedging
40% $470,240 $516,000 –$45,760
k. The probability distribution of payments when owning a call option is shown below:
Exercise
Probability FSR Option? $ Needed (incl. prem.)
40% .6450 Yes $488,000
40% .5878 No $478,240
20% .5890 No $479,200
l. Money market hedge
m. The forward hedge would be preferable to the call option hedge because it would be cheaper for any
of the three FSR scenarios.
n. The forward hedge is preferable to not hedging because it does as well or better than not hedging in
all three FSR scenarios.
Small Business Dilemma
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Managing Transaction Exposure 10
Hedging Decisions by the Sports Exports Company
1. Determine the amount of dollars received by the Sports Exports Company if the receivables to be
received in one month are not hedged under each of the two exchange rate scenarios.
ANSWER:
2. Determine the amount of dollars received by the Sports Exports Company if a put option is used to
hedge receivables in one month under each of the two exchange rate scenarios.
ANSWER:
3. Determine the amount of dollars received by the Sports Exports Company if a forward hedge is used
to hedge receivables in one month under each of the two exchange rate scenarios.
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Managing Transaction Exposure 11
ANSWER: The forward rate is $1.645. Therefore, the amount of dollars to be received regardless of
4. Summarize the results of dollars received based on an unhedged strategy, a put option strategy, and a
forward hedge strategy. Select the strategy that you prefer based on the information provided.
ANSWER:
Results Based Results Based
on Scenario I on Scenario II
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