Assumptions Values
Account recievable in 90 days (€) € 1,560,000
Hedged Hedged
If Chronos Time Pieces …… the Minimum the Maximum
Proportion of exposure to be hedged 70% 120%
Total exposure (€)€ 1,560,000 € 1,560,000
Case #1: Ending spot rate
Proportion uncovered (short) € 468,000 (€ 312,000)
Case #2: Ending spot rate
Proportion uncovered (short) € 468,000 (€ 312,000)
Benchmark: Full (100%) forward cover $1,914,120 $1,914,120
Problem 10.11 Chronos Time Pieces
This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for more
than the exposure (therefore creating a net short position) the firm could experience nearly unlimited losses or gains.
Chronos Time Pieces of Boston exports wrist watches to many countries, selling in local currencies to watch stores and distributors.
Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the
forward market, but occasionally with options. Chronos’s foreign exchange policy is such that the 70% hedge may be increased up to a
120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has
issued a 90-day invoice to its buyer for €1,560,000. The current spot rate is $1.2224/€, the 90-day forward rate is $1.2270/€.
Chronos’s treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently believes the
euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16/€.
Construction payment due in six-months (A/P, quetzals) 8,400,000
Expected spot rate in six-months (quetzals/$):
Highest expected rate (reflecting a significant devaluation) 8.0000
What realistic alternatives are available to Farah for making payments? Which method would you select and why?
What realistic alternatives are available to Farah Jeans? Cost Certainty
1. Wait six months and make payment at spot rate
2. Purchase quetzals forward six-months 1,183,098.59$ Certain
(A/P divided by the forward rate)
3. Transfer dollars to quetzals today, invest for six-months
quetzals needed today (A/P discounted 180 days) 7,850,467.29
Problem 10.12 Farah Jeans
Farah’s treasury manager, concerned about the Guatemalan economy, wonders if Farah should be hedging its foreign exchange
risk. The manager’s own forecast is as follows:
Farah Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment of
Q8,400,000 is due in six months. (“Q” is the symbol for Guatemalan quetzals.) Farah Jeans uses 20% per annum as its weighted
average cost of capital. Today’s foreign exchange and interest rate quotations are:
a. What will be the amount of foreign exchange gain (loss) upon settlement?
b. If Jason hedges the exposure with a forward contract, what will be the net foreign exchange gain (loss) on settlement?
Spot Rate Forward Rate Days Forward
Date Event ($/£) ($/£) of Forward Rate
February 1 Price quotation for Pegg
1.7850 1.7771 210
Analysis
a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Pegg Metropolitan, and the shipment
is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement,
the difference being the foreign exchange gain (loss).
b. The vlaue of the foreign exchange gain (loss) will depend upon when Jason actually purchases the forward contract. Because
many firms do not define an “exposure” as arising until the date that the product is shipped (loss of physical control over
the goods) and the sale is booked on the income statement, that is a common date for the purchase of the forward contract.
Forward contract purchased on June 1
Forward contract purchased on March 1
Problem 10.13 Burton Manufacturing
Jason Stedman is the director of finance for Burton Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory
management. Burton’s system combines a low-cost active tag that is attached to inventory items (the tag emits a low-grade radio frequency)
with custom-designed hardware and software that tracks the low-grade emissions for inventory control. Burton has completed the sale of a
inventory management system to a British firm, Pegg Metropolitan (UK), for a total payment of £1,000,000. The exchange rates shown were
available to Burton on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days.
1.7465 1.7381 180
1.7689 1.7602 90
1.7840 1.7811 30
1.7290 ——— ———
Assumptions Values
Shipment of phosphates from Morocco, Moroccan dirhams 6,000,000
Micca’s cost of capital (WACC) 14.000%
Risk Management Alternatives Values Certainty
1. Remain uncovered, making the dirham payment in six months
at the spot rate in effect at that date
Account payable (dirhams) 6,000,000
2. Forward market hedge. Buy dirhams forward six months.
3. Money market hedge. Exchange dollars for dirhams now, invest for six months.
Account payable (dirhams) 6,000,000.00
Problem 10.14 Micca Metals, Inc.
Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available from Bank Al-
Maghrub at a premium of 2%. Six-month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are
available at a premium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transaction
exposure. What is your recommendation?
Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific
precious metals and materials which are used in a variety of pigment applications in many other industries including cosmetics,
appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from
Morocco for 6,000,000, dirhams, payable in six months.
4. Call option hedge. (Need to buy dirhams = call on dirhams)
Option principal 6,000,000.00
Current spot rate, dirhams/$ 10.00
Assumptions Value
90-day A/R in pounds £3,000,000.00
Spot rate, US$ per pound ($/£)$1.7620
90-day forward rate, US$ per pound ($/£)$1.7550
Alternative #1: Remain Uncovered Rate ($/pound) Proceeds
Value of A/R will be (3 million pounds x ending spot rate ($/pound))
Alternative #2: Forward Contract Hedge Rate ($/pound) Proceeds
Sell the pounds forward 3-months locking in the forward rate
Pound A/R at the forward rate (pounds x forward) $1.7550 $5,265,000.00
Alternative #3: Money Market Hedge Rate ($/pound) Proceeds
Borrows against the A/R, receiving £ up-front, exchanging into US$.
Strike Rate ($/pnd) Strike Rate ($/pnd)
Alternative #4: Put Option Hedges 1.75 1.71
Option premium 1.500% 1.000%
Ganado — the same U.S.-based company as discussed in this chapter, has concluded a second larger sale of telecommunications
equipment to Regency (U.K.). Total payment of £3,000,000 is due in 90 days. Maria Gonzalez has also learned that Ganado will only
be able to borrow in the United Kingdom at 14% per annum (due to credit concerns of the British banks). Given the following
exchange rates and interest rates, what transaction exposure hedge is now in Ganado’s best interest?
Problem 10.15 Maria Gonzalez and Ganado
Put options on the British pound: Strike rates, US$/pound ($/£)
Maria Gonzalez’s expected spot rate in 90-days, US$ per pound ($/£)$1.7850
Total premium cost, in 90-days $81,668.70 $54,445.80
Analysis: Maria Gonzalez would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is less
attractive as result of the higher borrowing costs in the UK now. The two put options yield unattractive amounts if they had to be
exercised. As shown, the $1.75 strike price put option would be superior to the forward if the ending spot rate was $1.7825 or higher;
Assumptions Values Today is May 1
90-day Forward rate, $/€$1.1060 Exchange Rate
Options on euros Strike ($/euro) Call Option Put Option
August maturity options $1.1000 3.0% 2.0%
November maturity options $1.1000 2.6% 1.2%
Valuation of Alternative Hedges August Receivable November Receivable
Amount of receivable, in euros € 2,000,000 € 2,000,000
a. Hedge in the forward market
Amount of receivable, in euros € 2,000,000 € 2,000,000
b. Hedge in the money market
Amount of receivable, in euros € 2,000,000 € 2,000,000
of 3.0%, and November call options at $1.1000/€ were available at a 2.6% premium.
3. Hedge with foreign currency options. August put options were available at strike price of $1.1000/€ for a premium of 2.0% per contract, and
Problem 10.16 Larkin Hydraulics
1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/€ and the 6-month forward quote was $1.1130/€.
By the time the order was received and booked on May 1st, the euro had strengthened to $1.1000/€, so the sale was in fact worth €4,000,000
On May 1st, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to Rebecke-
Terwilleger Company of the Netherlands for €4,000,000, payable €2,000,000 on August 1st and €2,000,000 on November 1st. Larkin derived its
price quote of €4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/€.
Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long-term
debt. U.S. T-bills yield 3.6% per annum. What should Larkin do?
c. Hedge with options
Amount of receivable, in euros € 2,000,000 € 2,000,000
d. Do nothing (remain uncovered)
Amount of receivable, in euros € 2,000,000 € 2,000,000
Ending spot exchange rate ($/€)??? ???
US Parent Company Sells Product to a Barcelona Subsidiary
Parameters Value
Sales price 500,000$
Barcelona P&L: No hedge Rate ($/€) Entry
Payable as booked (initial spot) 1.0640 € 469,924.81
Payable as settled (ending spot) 1.0980 € 455,373.41
FX gain (loss) € 14,551.41
FX gain (loss) -€ 1,106.75
Problem 10.17 Navarro’s Intra-Company Hedging
Navarro was a U.S.-based multinational company which manufactured and distributed specialty materials for sound-
proofing construction. It had recently established a new European subsidiary in Barcelona, Spain, and was now in the
process of establishing operating rules for transactions between the U.S. parent company and the Barcelona subsidiary.
Ignacio Lopez was International Treasurer for Navarro, and was leading the effort at establishing commercial policies for
the new subsidiary.
a) If the product was invoiced in US dollars, the US parent has no direct exposure, but the Spanish subsidiary in
Barcelona does.
a. Which unit would have suffered the gain (loss) on currency exchange if intra-company sales were invoiced in U.S.
dollars ($), assuming both completely unhedged and fully hedged?
b. Which unit would have suffered the gain (loss) on currency exchange if intra-company sales were invoiced in euros (€),
assuming both completely unhedged and fully hedged?
Uncovered Forward Cover Money Market Call Option
Payment (exposure) $30,000,000 $30,000,000 $30,000,000 $30,000,000
Effective ending rate (Won/$) 792 794 792 790
Bank Balance Uncovered Forward Cover Money Market Call Option
Beginning balance 25,000,000,000 25,000,000,000 25,000,000,000 25,000,000,000
Initial deductions 0 0 -23,645,320,197 -696,000,000
balance for interest 25,000,000,000 25,000,000,000 1,354,679,803 24,304,000,000
Interest earnings 312,500,000 312,500,000 16,933,498 303,800,000
Balance at day 89 25,312,500,000 25,312,500,000 1,371,613,300 24,607,800,000
Settlement of payment -23,760,000,000 -23,820,000,000 -23,700,000,000
Final Balance 1,552,500,000 1,492,500,000 1,371,613,300 907,800,000
Total cost 23,760,000,000 23,820,000,000 23,940,886,700 24,404,700,000
How should KAL plan to make the payment to Boeing if KAL’s goal is to maximize the amount of won cash left in the bank at the end of the three month
period? Make a recommendation and defend it.
Problem 10.18 Korean Airlines
Korean Airlines (KAL) has just signed a contract with Boeing to purchase two new 747-400’s for a total of $60,000,000, with payment in two equal
tranches. The first tranche of $30,000,000 has just been paid. The next $30,000,000 is due three months from today. KAL currently has excess cash of
25,000,000,000 won in a Seoul bank, and it is from these funds that KAL plans to make its next payment.
The current spot rate is won 800/$, and permission has been obtained for a forward rate (90 days), won 794/$. The 90 day Eurodollar interest rate is
6.000%, while the 90 day Korean won deposit rate (there is no Euro-won rate) is 5.000%. KAL can borrow in Korea at 6.250%, and can probably borrow
A three month call option on dollars in the over-the-counter market, for a strike price of won 790/$ sells at a premium of 2.9%, payable at the time the
option is purchased. A 90 day put option on dollars, also at a strike price of won 790/$, sells at a premium of 1.9% (assuming a 12% volatility). KAL’s
foreign exchange advisory service forecasts the spot rate in three months to be won792/$.
Current spot rate (Won/$) 800 800 800 800
Option premium (call) 2.900%
Eurodollar interest 6.000% 6.000%
US dollar interest borrow 9.375% 9.375%
Korean won interest 5.000% 5.000% 5.000% 5.000%
Eurodollar deposit rate
6.000%
US dollars for Payable
29,556,650$ ↔ ↔ 1.0150 ↔ ↔ 30,000,000$
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Korean Airlines Money Market Hedge
The challenge with the Korean Money Market Hedge is that it is a payable — a payable form a Korean won cash balance. A
MM Hedge for a payable is to simply transfer money into the target currency at the start of the period (the front end of the
box), and then to have that money earn interest on deposit for the time period until payment is due.
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