20 Managing Transaction Exposure
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 presumed to be 1.0%, while the real interest rate in Thailand is presumed to be 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:
a. [1.02/1.11] – 1 = -8.11%
40. Hedging Decision. Chicago 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. Chicago 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 $1.11,
an expiration date of one year from today, and a premium of $.06 per unit. Estimate the dollar cash
flows it will receive as a result of using each strategy. Which hedge is optimal?
Managing Transaction Exposure 21
ANSWER
Calculation of Forward Rate
Remain Unhedged
Money Market Hedge
Put Option Hedge
41. Overhedging. Denver Co. is about to order supplies from Canada that are denominated in
Canadian dollars (C$). 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
22 Managing Transaction Exposure
one-year 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 $.59. Show your work.
ANSWER
Price per load of supplies (C$)
1,000,000
3,000,000
2,000,000
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 peso 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
Since interest rate parity exists, determine the forward rate premium based on existing interest rates:
Managing Transaction Exposure 23
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 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 future 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.
ANSWER: More than, because there is an option premium on options and the expectation is that the
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.
ANSWER: The forward contract does not require an option premium. The forward rate is same as
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 $.006. Evar Imports is concerned about a modest
appreciation in the Swiss franc.
a. Describe how Evar Imports could construct a bullspread using the first two options. What is the
cost of this hedge? When is this hedge most effective? When is it least effective?
b. Describe how Evar Imports could construct a bullspread using the first option and the third
option. What is the cost of this hedge? When is this hedge most effective? When is it least
effective?
c. Given your answers to parts (a) and (b), what is the tradeoff involved in constructing a bullspread
using call options with a higher exercise price?
24 Managing Transaction Exposure
ANSWER:
a. Evar Imports Inc. would buy the first option and write the second option. It would pay SF62,500
46. Hedging with a Bearspread. (See the chapter appendix.) Marson Inc. has some customers in Canada
and frequently receives payments denominated in Canadian dollars (C$). 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:
a. Marson Inc. would construct a bearspread by writing the option with the $.72 exercise price and
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
Managing Transaction Exposure 25
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.
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:
a. Brooks could construct a long straddle to hedge its positions in dirham. If the negotiations are
buy four put options and four call options.
b.
Net Cash Flow = +2 million Dirham
Dirham value = $.11 in three
months
26 Managing Transaction Exposure
Net Cash Flow = –2 million Dirham
Dirham value = $.11 in three
months
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
Managing Transaction Exposure 27
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 future spot
rate one year from now. You consider these alternatives:
*hedge with one-year forward contract,
*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.
ANSWER: Remain unhedged since the future spot rate is expected to be $.85. The forward contract
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:
28 Managing Transaction Exposure
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.
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
a. Narto Co. could borrow the amount of Swiss francs so that the 500,000 Swiss francs to be
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, lower, 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 point in time,
Managing Transaction Exposure 29
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,
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.
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 the payables be higher, lower, or the same as the total expected dollar cash outflows that
Mateo Co. will pay? Explain.
30 Managing Transaction Exposure
ANSWER
The dollar cash outflows will be higher for San Fran Co. than for Mateo Co. Because both countries
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?
ANSWER: (See spreadsheet attached.) Based on the analysis, it appears that Blades should hedge its
baht exposure. The money market hedge appears to be the most appropriate for Blades because it
results in the highest dollar value for the net baht inflows. There is only a 20 percent chance that
remaining unhedged will result in a higher dollar amount to be received in 90 days.
Calculation of Net Baht Paid or Received in 90 Days:
Baht-denominated inflow:
Pairs sold
45,000
× Revenue per pair
4,594
= Number of baht received in 90 days
206,730,000
Baht-denominated outflow:
Pairs manufactured
18,000
× Estimated cost per pair
3,000
= Number of baht needed in 90 days
54,000,000
Net inflow (outflow) in baht anticipated in 90 days
152,730,000
Forward Hedge:
Sell baht 90 days forward:
Baht-denominated revenue
152,730,000
– Forward rate of baht
0.0215
= Dollars to be received in 90 days
3,283,695.00
Money Market Hedge:
Managing Transaction Exposure 31
Remain Unhedged:
Total Dollars Received
Possible Spot Rate in 90 Days ($)
from Converting Baht
3,054,600
3,253,149
3,314,241
3,360,060
3,512,790
3,589,155
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
pound exposure. The money market hedge appears to be the most appropriate for Blades, because it
Calculation of Pounds Received in 90 Days:
Pound-denominated inflow:
Pairs sold
× Revenue per pair
= Number of pounds received in 90 days
Forward Hedge:
Pound-denominated revenue
× Forward rate of pound
= Dollars to be received in 90 days
Money Market Hedge:
Amount in pounds borrowed (4,000,000/1.02)
Dollars received from converting pounds (3,921,568.63 × $1.50)
Dollars accumulated after 90 days (5,882,352.94 × 1.021)
Dollars accumulated after 90 days (3,377,682.69 × 1.021)
3,448,614.03
32 Managing Transaction Exposure
Put Option Hedge:
Purchase put option:
Total Dollars Total Dollars
Premium Received per Received from
Possible Spot per Unit Unit (after Converting
Rate in 90 Paid for Exercise accounting for 4,000,000
Remain Unhedged:
Possible Spot Total Dollars
Rate in 90 Received from
Days ($) Converting Pounds Probability
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
Managing Transaction Exposure 33
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?
ANSWER: Blades could import sufficient materials to completely offset the baht-denominated
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.
ANSWER: Blades has fixed-price exporting arrangements with both the Thai and British customers
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:
34 Managing Transaction Exposure
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.
Managing Transaction Exposure 35
h. The probability distribution for FSR is:
Probability FSR
40% $.6450
40% $.5878
20% $.5890
i. The probability distribution for payments if Blackhawk does not hedge is:
j. The probability distribution for the real cost of hedging is determined below:
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
36 Managing Transaction Exposure
The U.S. dollars that would be needed when using the forward hedge is NZ$800,000 × $.5878 =
$470,420. This amount is less than the amount that would be needed when using the money market
hedge.
Small Business Dilemma
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:
Scenario I: A 3% rate of depreciation reflects a future spot rate (in one month) of:
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:
Scenario I: The put option would be hedged, resulting in the conversion of 10,000 pounds at an
exchange rate of $1.645:
Managing Transaction Exposure 37
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.
ANSWER: The forward rate is $1.645. Therefore, the amount of dollars to be received regardless of
the exchange rate scenario is:
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