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CHAPTER8MANAGEMENT OFTRANSACTION EXPOSURESUGGESTEDANSWERS ANDSOLUTIONS TOEND-OF-CHAPTER QUESTIONSAND PROBLEMSQUESTIONS
1.How would you definetransaction exposureHow isit differentfrom economicexposureAnswer:Transaction exposureis thesensitivity ofrealized domesticcurrency valuesof the firms contractualcash flowsdenominated inforeign currenciesto unexpectedchanges inexchange rates.Unlike economicexposure,transaction exposureis well-defined andshort-term.
2.Discuss andcompare hedgingtransaction exposure using the forward contractvs.money marketinstruments.When dothe alternativehedging approachesproduce the same resultAnswer:Hedging transactionexposure bya forward contract is achieved byselling orbuying foreigncurrencyreceivables orpayables forward.On the other hand,money markethedge isachieved byborrowingor lendingthe presentvalue offoreign currencyreceivables orpayables,thereby creatingoffsettingforeign currencypositions.If theinterest rateparity isholding,the two hedging methodsareequivalent.
3.Discuss andcompare the costs of hedging viathe forwardcontract and the optionscontract.Answer:There isno up-front cost of hedging by forwardcontracts.In the case of options hedging,however,hedgers shouldpay the premiums for the contractsup-front.The cost of forwardhedging,however,may berealized expost when the hedgerregrets his/her hedgingdecision.
4.What arethe advantages of acurrency optionscontract asa hedgingtool comparedwith and theforward hedges.b Assumingthat the forward exchange rate is the bestpredictor of the future spot rate,computethe expected future dollar cost of meeting this obligation whenthe optionhedge isused.c At what future spot ratedo youthink PCCmay beindifferent between the option and forward hedgeSolution:a In the case of forwardhedge,the dollar cost will be500,000,000/110$4,545,
455.二In thecase ofmoney markethedge,the futuredollar costwill be:500,000,
0001.08/l.05124$4,147,
465.二b Theoption premiumis:.014/100500,000,000=$70,
000.Its future value will be$70,
0001.08=$75,
600.At the expected future spot rate of$.0091=1/110,which ishigher than the exerciseof$.0081,PCC will exercise itscall option and buy¥500,000,000for$4,050,000=500,000,OOOx.
0081.The totalexpected costwill thusbe$4,125,600,which is the sumof$75,600and$4,050,
000.c Whenthe optionhedge isused,PCC willspend“at mostv$4,125,
000.On theother hand,whenthe forwardhedging isused,PCC willhave to spend$4,545,455regardless of the future spot rate.This meansthat the options hedgedominates theforwardhedge.At nofuture spot rate,PCC will beindifferent betweenforward and options hedges.
7.Airbus sold an aircraft,A400,to DeltaAirlines,a U.S.company,and billed$30million payablein six months.Airbus isconcerned with the euro proceeds frominternational salesand wouldliketo controlexchange risk.The currentspot exchange rate is$
1.05/€and six-month forward exchangerate is$
1.10/€at themoment.Airbus canbuy asix-month put option on U.S.dollars with a strikeprice of€
0.95/$for apremium of€
0.02per U.S.dollar.Currently,six-month interest rateis
2.5%in the euro zoneand
3.0%in the U.S.a.Compute theguaranteed europroceeds from theAmerican saleif Airbusdecides to hedgeusing a forwardcontract.b.If Airbusdecides to hedge usingmoney marketinstruments,what actiondoes Airbusneed to takeWhat would be theguaranteed europroceeds from the American sale in this casec.If Airbusdecides to hedge usingput optionsonU.S.dollars,what would be theexpected europroceeds from the AmericansaleAssume thatAirbus regardsthe currentforward exchange rate asanunbiased predictorof the future spot exchange rate.d.Atwhat futurespot exchange ratedo youthink Airbus will beindifferent betweenthe optionandmoney markethedgeSolution:a.Airbuswill sell$30million forwardfor€27,272,727=$30,000,000/$
1.10/€.b.Airbuswill borrowthe presentvalue of the dollarreceivable,i.e.,$29,126,214=$30,000,000/
1.03,and thensell the dollar proceedsspot foreuros:€27,739,
251.This is the euroamount thatAirbusis going to keep.c.Since theexpected futurespot rate is less thanthe strike price of theput option,i.e.,€
0.909K€
0.95,Airbus expectsto exercise the optionand receive€28,500,000=$30,000,000€
0.95/$.This isgross proceeds.Airbus spent€600,000=
0.02x30,000,000upfront forthe optionand itsfuture costis equalto€615,000=€600,000x
1.
025.Thus thenet europroceeds from theAmericansale is€27,885,000,which is thedifference betweenthe grossproceeds andthe optioncosts.d.At theindifferent futurespot rate,the followingwill hold:€28,432,732=S30,000,000-€615,
000.TSolving forwe obtain the“indifference”futurespotexchange rate,i.e.,€
0.9683/$,ST,or$
1.0327/€.Note that€28,432,732is the futurevalue of the proceeds undermoney markethedging:€28,432,732=€27,739,
2511.
025.Suggested solutionfor MiniCase:Chase Options,Inc.[See Chapter13forthecase text]Chase Options,Inc.Hedging ForeignCurrency ExposureThrough CurrencyOptionsHarvey A.PoniachekI.Case SummaryThiscase reviewsthe foreign exchange options market and hedging.It presentsvarious internationaltransactionsthat requirecurrency optionshedging strategiesby thecorporations involved.Seventransactions undera varietyof circumstancesare introducedthat requirehedgingbycurrency options.The transactionsinvolve hedgingof dividendremittances,portfolio investmentexposure,andstrategic economiccompetitiveness.Market quotationsare providedfor optionsand optionshedgingratios,forwards,and interest rates forvarious maturities.II.Case Objective.The caseintroduces thestudent to the principlesof currencyoptionsmarketandhedgingstrategies.The transactionsare ofvarious typesthat oftenconfront companiesthat areinvolved inextensiveinternational businessor multinationalcorporations.The caseinduces studentsto acquirehands-onexperience inaddressing specificexposure andhedging concerns,including howto applyvarious marketquotations,which hedgingstrategy ismost suitable,and howto addressexposure inforeign currencythroughcross hedgingpolicies.III.Proposed AssignmentSolution
1.The companyexpects DM100million inrepatriated profits,and does not wantthe DM/$exchange rateat which theyconvert thoseprofits torise above
1.
70.They can hedge thisexposureusing DM putoptionswitha strike price of
1.
70.If the spot rate rises above
1.70,they canexercise the option,while ifthat ratefalls they can enjoyadditional profitsfrom favorableexchange ratemovements.To purchasethe optionswould requirean up-front premium of:DM100,000,000x
0.0164=DM1,640,
000.With astrike priceof
1.70DM/$,this wouldassure theU.S.company ofreceiving atleast:DM100,000,000-DM1,640,000x1+
0.085106x272/360=DM98,254,544/
1.70DM/$=$57,796,791by exercisingtheoption if the DM depreciated.Note that the proceedsfrom the repatriated profitsarereduced by the premiumpaid,which isfurther adjustedbytheinterest foregoneon thisamount.However,if the DM wereto appreciaterelative to the dollar,the companywould allow theoption toexpire,and enjoygreater dollar proceedsfromthis increase.Should forwardcontracts be used tohedge thisexposure,theproceedsreceived would be:DM100,000,000/
1.6725DM/$=$59,790,732,regardless of the movementof the DM/$exchange rate.While thisamount isalmost$2million morethanthat realizedusing optionhedges above,there isno flexibilityregarding the exercise date;if thisdate differsfrom that atwhichtherepatriateprofits areavailable,the companymay beexposedto additionalfurther currentexposure.Further,there isno opportunityto enjoyany appreciationin theDM.If thecompany wereto buy DM putsas above,and sell an equivalentamount incalls withstrike price
1.647,the premiumpaid wouldbe exactlyoffset bythe premiumreceived.This wouldassure that theexchange raterealized wouldfall between
1.647and
1.
700.If theraterises above
1.700,the companywillexercise itsput option,and ifit fellbelow
1.647,theotherparty woulduse itscall;forany ratein between,both optionswouldexpire worthless.The proceedsrealized wouldthen fallbetween:DM100,00,000/
1.647DM/$=$60,716,454andDM100,000,000/
1.700DM/$=$58,823,
529.This wouldallowthecompany someupside potential,while guaranteeingproceeds atleast$1milliongreater thanthe minimumfor simplybuying aput asabove.Buy/Sell OptionsDM/$“Put”“Call”CallSpot PutPayoff ProfitsProfits Net ProfitPayoff
1.601,742,84601,742,84660,716,4560,716,
45441.611,742,84601,742,84660,716,4560,716,
45441.621,742,84601,742,84660,716,4560,716,
45441.631,742,84601,742,84660,716,4560,716,
45441.641,742,84601,742,84660,716,4560,716,
45441.651,742,84660,606,061,742,846060,606,
06111.661,742,84660,240,961,742,846060,240,
96441.671,742,84659,880,241,742,846059,880,
24001.681,742,84659,523,811,742,846059,523,
8101.691,742,84659,171,591,742,846059,171,
59881.701,742,84658,823,521,742,846058,823,
52991.711,742,84658,823,521,742,846058,823,
52991.721,742,84658,823,521,742,846058,823,
52991.731,742,84658,823,521,742,846058,823,
52991.741,742,84658,823,521,742,846058,823,
52991.751,742,84658,823,521,742,846058,823,
52991.761,742,84658,823,521,742,846058,823,
52991.771,742,84658,823,521,742,846058,823,
52991.781,742,84658,823,521,742,846058,823,
52991.791,742,84658,823,521,742,846058,823,
52991.801,742,84658,823,521,742,846058,823,
52991.811,742,84658,823,521,742,846058,823,
52991.821,742,84658,823,521,742,846058,823,
52991.831,742,84658,823,521,742,846058,823,
5291.841,742,84658,823,521,742,846058,823,
52991.851,742,84658,823,521,742,846058,823,5299Since the firm believesthat thereisagood chancethat thepound sterlingwill weaken,lockingthem into a forwardcontract wouldnot beappropriate,because theywould losethe opportunitytoprofit fromthis weakening.Their hedgestrategy shouldfollow for an upside potential tomatch theirviewpoint.Therefore,they shouldpurchase sterlingcall options,paying apremium of:5,000,000STG x
0.0176=88,000STG.If the dollar strengthensagainst thepound,the firmallows theoptiontoexpire,and buyssterlingin the spot marketatacheaper pricethan theywould havepaid for a forwardcontract;otherwise,the sterlingcalls protectagainst unfavorabledepreciation of the dollar.Because thefund manageris uncertainwhen hewillsell the bonds,he requiresa hedgewhich willallowflexibility asto the exercise date.Thus,options arethe bestinstrument forhim touse.He canbuy A$puts tolock ina floorof
0.72A$/$.Since heis willingto foregoany furthercurrencyappreciation,he cansell A$calls withastrikepriceof
0.8025A$/$to defraythe cost of hishedgein facthe earnsa netpremium ofA$100,000,000x
0.007234-
0.007211=A$2,300,while knowingthat hecan treceive lessthan
0.72A$/$when redeeminghis investment,and canbenefitfrom asmall appreciation of theA$.Example#3:Problem:Hedge principaldenominated inA$into US$.Forgo upsidepotential to buy floorprotection.I.Hedge bywriting callsand buyingputs1Write callsfor$/A$@
0.8025Buy putsfor$/A$@
0.72#contracts needed=Principal inA$/Contract size100,000,000A$/100,000A$=1002Revenue fromsale ofcalls=#contracts sizeof contractpremium$75,573=100100,000A$.007234$/A$1+.0825195/3603Total cost of puts=#contractssize ofcontractpremium$75,332=100100,000A$.007211$/A$1+.0825195/3604Put payoffIfspot falls below
0.72,fund managerwillexerciseputIf spot risesabove
0.72,fund managerwill letput expire5Call payoffIfspotrisesabove.8025,call willbeexercisedIf spotfallsbelow.8025,call wi116NetexpirepayoffSee followingTable fornet payoffAustralian DollarBond HedgeStrike“Put”Call“CallPrice PutPayoff PrincipalPayoff PrincipalNetProfit75,573072,000,
2410.6075,33272,000,
0000.6175,33272,000,00075,573072,000,
2410.6275,33272,000,00075,573072,000,
2410.6375,33272,000,00075,573072,000,
2410.6475,33272,000,00075,573072,000,
2410.6575,33272,000,00075,573072,000,
2410.6675,33272,000,00075,573072,000,
2410.6775,33272,000,00075,573072,000,
2410.6875,33272,000,00075,573072,000,
2410.6975,33272,000,00075,573072,000,
2410.7075,33272,000,00075,573072,000,
2410.7175,33272,000,00075,573072,000,
2410.7275,33272,000,00075,573072,000,
2410.7375,33275,573073,000,24173,000,000Answer:The mainadvantage ofusing optionscontracts forhedging isthat thehedger candecide whetherto exercise optionsupon observingthe realizedfuture exchange rate.Options thusprovide a hedgeagainst expost regretthat forwardhedger mighthave tosuffer.Hedgers canonly eliminate the downsiderisk whileretaining theupsidepotential.
5.Suppose your company haspurchased aput option on theGerman markto manageexchange exposureassociatedwith anaccount receivabledenominated inthat currency.In thiscase,your companycanbe saidto havean insurancepolicy onits receivable.Explain inwhat sensethis isso.Answer:Your companyin thiscase knowsin advancethat it will receivea certainminimum dollaramountno matterwhat mighthappen tothe$/€exchange rate.Furthermore,if theGerman markappreciates,yourcompanywill benefitfromtherising euro.
6.Recent surveysof corporateexchange riskmanagement practicesindicate thatmany U.S.firmssimply do not hedge.How would you explainthis resultAnswer:There can be manypossible reasonsfor this.First,many firms may feelthat theyare notreallyexposed toexchange riskdue toproduct diversification,diversified marketsfor theirproducts,etc.Second,firms maybe usingself-insurance againstexchange risk.Third,firms mayfeel thatshareholderscan diversifyexchange riskthemselves,rendering corporaterisk managementunnecessary.
7.Should afirm hedgeWhy or why notAnswer:In aperfect capitalmarket,firmsmay not needtohedgeexchange risk.But firmscan addtotheir valueby hedgingif marketsare imperfect.First,if managementknows about the firm sexposure betterthan shareholders,the firm,not itsshareholders,should hedge.Second,firms maybeable tohedge ata lower cost.Third,if defaultcosts aresignificant,corporate hedgingcanbe justifiablebecause itreduces theprobability of
0.7475,33274,000,00075,573074,000,
2410.7575,33275,573075,000,24175,000,
0000.7675,33275,573076,000,24176,000,
0000.7775,33275,573077,000,24177,000,
0000.7875,33275,573078,000,24178,000,
0000.7975,33275,573079,000,24179,000,
0000.8075,33275,573080,000,24180,000,
0000.8175,332075,57380,250,24180,250,
0000.8275,332075,57380,250,24180,250,
0000.8375,332075,57380,250,24180,250,
0000.8475,332075,57380,250,24180,250,
0000.8575,332075,57380,250,0080,250,
24104.The Germancompany isbidding ona contractwhich theycannot becertain ofwinning.Thus,theneed toexecute acurrency transactionis similarlyuncertain,and usingaforwardor futuresasa hedge is inappropriate,because itwould forcethem toperform evenif theydonotwin thecontract.Using asterling putoption asahedgefor thistransaction makesthe mostsense.For apremium of:12million STGx
0.0161=193,200STG,theycanassure themselvesthat adversemovements in the poundsterlingexchange rate will notdiminish theprofitability of the projectand hencethe feasibilityof their bid,while at thesametime allowingthe potentialfor gainsfrom sterlingappreciation.
5.Since AMCin concerned abouttheadverse effectsthat astrengthening ofthe dollarwould haveonits business,we needto createa situationin whichit willprofit fromsuch anappreciation.Purchasing ayen putoradollar callwill achievethis objective.The datain Exhibit1,row7representa10percent appreciationofthe dollar
128.15strike vs.
116.5forward rateand canbeusedtohedge againsta similarappreciationofthe dollar.For everymillion yenof hedging,thecostwouldbe:Yen100,000,000x
0.000127=127Yen.To determinethe breakevenpoint,we needto compute the value of thisoptionif thedollarappreciated10percent spotrose to
128.15,and subtractfrom itthepremiumwe paid.This profitwould becomparedwith theprofit earnedon fiveto10percent ofAMC ssales whichwouldbelost asa resultofthedollarappreciation.The numberofoptions to bepurchased whichwould equalizethese twoquantitieswould representthe breakevenpoint.Example#5:Hedge theeconomic costofthedepreciating Yento AMC.If weassume thatAMC salesfall indirect proportionto depreciationin theyen i.e.,a10percentdecline inyen and10percent declinein sales,then wecanhedgethe fullvalueofAMC ssales.I haveassumed$100million insales.1Buy yenputs#contracts needed=Expected SalesCurrent¥/$Rate/Contract size9600=$100,000,000120¥/$/¥1,250,0002Total Cost=#contractscontract sizepremium$1,524,0009600¥1,250,000$
0.0001275/¥、3Floor rate=Exercise-Premium
128.1499¥/$=
128.15¥/$-$1,524,000/12,000,000,000¥4The payoffchanges dependingon thelevel ofthe¥/$rate.The followingtable summarizesthepayoffs.An equilibriumis reachedwhenthe spot rateequals thefloorrate.AMC ProfitabilityYen/$Spot PutPayoff SalesNetProfit1201,524,990100,000,00098,475,0101211,524,99099,173,66497,648,5641221,524,99098,360,65696,835,6661231,524,99097,560,97686,035,9861241,524,99096,774,19495,249,2041251,524,99096,000,00094,475,0101261,524,99095,238,09593,713,105127847,82994,488,18993,640,360128109,64093,750,00093,640,360129617,10493,023,25693,640,3601301,332,66892,307,69293,640,3601312,037,30791,603,05393,640,3601322,731,26990,909,09193,640,3601333,414,79690,225,66493,640,3601344,088,12289,552,23993,640,3601354,751,43188,888,88993,640,3601365,405,06688,235,29493,640,3601376,049,11887,591,24193,640,3601386,683,83986,966,52293,640,3601397,308,42586,330,93693,640,3601407,926,07585,714,28693,640,3601418,533,97785,106,38393,640,3601429,133,31884,507,04293,640,3601439,724,27683,916,08493,640,36014410,307,02783,333,33393,640,36014510,881,74082,758,62193,640,36014611,448,57982,191,78193,640,36014712,007,70781,632,65393,640,36014812,569,27981,081,08193,640,36014913,103,44880,536,91393,640,36015013,640,36080,000,00093,640,360The parenthas aDM payable,and Lira receivable.It hasseveral waysto coverits exposure;forwards,options,or swaps.The forwardwouldbeacceptable fortheDMloan,because ithas aknown quantityand maturity,butthe Liraexposure wouldretain someof itsuncertainty because these factorsare notassured.The parentcould buyDM callsand Liraputs.This wouldallow themtotakeadvantage offavorablecurrency fluctuations,but wouldrequire payingfor twopremiums.Finally,they couldswap theirLirareceivableinto DM.This wouldleave a net DMexposure whichwouldprobably besmaller thanthe amount oftheloan,which theycould hedgeusing forwardsoroptions,depending upontheir riskoutlook.The companyhas Lirareceivables,and isconcernedaboutpossible depreciationversus thedollar.Because ofthe highcosts ofLira options,they insteadbuyDMputs,making theassumption thatmovementin theDM andLira exchange rates versusthedollarcorrelate we
11.A hedgeof lirausingDMoptions willdepend onthe relationshipbetween lira FX ratesand DMoptions.This relationshipcould bedetermined usinga regressionof historicaldata.The hedgedrisk asa percentoftheopen riskcanbeestimated as:Square Rootvar error/b2var1iraFXrate*100The“cost”oftherisk oftheDMhedge wouldhave to be comparedwiththecostofthe expensiveliraoptions.Whichever hedgeis“cheaper”i.e.,lowercostfor samerisk orlower riskfor samecost shouldbeselected.This hedgemust beclosely monitored,however,to makesure thatthis relationshipholdstrue.If itdoesnot,this ubasisrisk”can causethe ratioof DMversus Lirato change,so thattheappropriate amount of cross-hedgeisdifferent.If thatamount isnot thenadjusted,anetcurrencyexposure couldresult,leaving thecompany opento additionalcurrency losses.default.Fourth,ifthefirm facesprogressive taxes,it canreduce tax obligations byhedging whichstabilizescorporate earnings.
8.Using anexample,discuss thepossible effectofhedgingonafirmstaxobligations.Answer:One canuse anexample similartothe one presentedin thechapter.
9.Explain contingentexposure anddiscuss theadvantagesofusing currencyoptionstomanage thistypeof currency exposure.Answer:Companies mayencounter asituation wherethey may or may not facecurrency exposure.Inthis situation,companies needoptions,not obligations,to buyor sella givenamountofforeignexchange they may ormaynotreceive orhave to pay.If companieseither hedgeusing forwardcontractsor donot hedgeat all,theymayface definitecurrencyexposure.
10.Explain cross-hedging anddiscuss thefactors determiningits effectiveness.Answer:Cross-hedging involveshedging a position in one assetby takingapositionin anotherasset.The effectivenessof cross-hedging woulddepend onthe strengthand stabilityoftherelationshipbetween thetwo assets.PROBLEMS
1.Cray Researchsold asuper computertotheMax PlanckInstitute inGermany oncredit andinvoiced€10million payablein sixmonths.Currently,the six-month forwardexchange rate is$
1.10/€andtheforeign exchangeadvisor forCray Researchpredicts thatthe spot rate islikely tobe$
1.05/€insixmonths.a What is theexpected gain/loss fromtheforwardhedgingb Ifyou werethe financialmanager ofCray Research,wouldyourecommend hedgingthis euroreceivableWhy orwhy notcSuppose theforeignexchangeadvisor predictsthatthe futurespot rate will be thesame astheforward exchangerate quotedtoday.Would yourecommend hedginginthiscase WhyorwhynotSolution:a Expectedgain$=10,000,
0001.10-
1.05=10,000,
000.05=$500,
000.d Iwould recommendhedging becauseCray Researchcan increasetheexpecteddollar receiptby$500,000and alsoeliminatethe exchange risk.e SinceI eliminaterisk withoutsacrificing dollarreceipt,I stillwould recommendhedging.
2.IBM purchasedcomputer chipsfrom NEC,a Japaneseelectronics concern,and wasbilled¥250millionpayable in three months.Currently,thespotexchangerate is¥105/$andthe three-month forwardrate is¥100/$.The three-month money market interest rateis8percent perannum intheU.S.and7percent perannum in Japan.The managementof IBMdecided tousethemoney markethedge todealwith thisyen accountpayable.a Explainthe processof amoney markethedge andcompute thedollar costof meetingthe yenobligation.b Conductthe cashflow analysisofthemoney markethedge.Solution:a.Let,s firstcomputethePV of¥250million,i.e.,250m/
1.0175=¥245,700,
245.7So ifthe aboveyen amountis investedtoday atthe Japaneseinterestratefor three months,thematurity valuewillbeexactly equalto¥25million which istheamountofpayable.To buy the aboveyenamount today,it willcost:$2,340,
002.34=¥250,000,000/
105.The dollarcostof meeting thisyen obligationis$2,340,
002.34as oftoday.bTransaction CFoCR
1.Buy yensspot-$2,340,
002.34with dollars¥245,700,
245.
702.Invest inJapan¥250,000,000-¥245,700,
245.
703.Pay yens-¥250,000,000Net cashflow-$2,340,
002.
343.You planto visitGeneva,Switzerland inthreemonthsto attendan internationalbusinessconference.You expectto incurthe totalcostofSF5,000for lodging,meals andtransportationduring yourstay.As oftoday,thespotexchangerateis$
0.60/SF andthethree-month forward rateis$
0.63/SF.You canbuythethree-month call option on SF withthe exerciserateof$
0.64/SF forthepremium of$
0.05per SF.Assume thatyour expectedfuturespotexchangerateisthesame astheforward rate.The three-month interestrateis6percent perannum inthe UnitedStates and4percent perannum inSwitzerland.a Calculateyour expecteddollarcostof buying SF5,000if youchoose tohedge viacall optiononSF.b Calculatethe futuredollarcostof meetingthis SFobligation ifyou decidetohedgeusing aforwardcontract.c Atwhatfuturespotexchangeratewillyou beindifferent betweentheforwardandoptionmarkethedgesd Illustratethe futuredollar costsofmeetingthe SFpayable against thefuturespot exchangerateunder boththe optionsand forwardmarket hedges.Solution:a Totaloption premium=.055000=$
250.In threemonths,$250is worth$
253.75=$
2501.
015.At theexpectedfuturespot rateof$
0.63/SF,which islessthantheexerciseprice,you dont expecttoexerciseoptions.Rather,you expecttobuySwiss francat$
0.63/SF.Since youaregoingtobuy SF5,000,you expecttospend$3,150=.63x5,
000.Thus,the totalexpected costofbuying SF5,000willbethe sumof$3,150and$
253.75,i.e.,$3,
403.
75.b$3,150=.635,
000.c$3,150=5,OOOx+
253.75,where xrepresents thebreak-even futurespot rate.Solving forx,we obtainx=$
0.57925/SF.Note thatatthebreak-even futurespotrate,options willnot beexercised.d Ifthe Swiss franc appreciatesbeyond$
0.64/SF,whichistheexercisepriceofcalloption,you willexercisetheoptionandbuy SF5,000for$3,
200.The totalcostofbuyingSF5,000willbe$3,
453.75=$3,200+$
253.
75.This isthe maximumyou willpay.$Coststrike price
4.Boeing justsigned acontract tosellaBoeing737aircraft toAir France.Air Francewill bebilled€20million whichis payablein oneyear.The currentspotexchangerateis$
1.05/€andthe one-year forwardrateis$
1.10/€.The annualinterestrateis
6.0%intheU.S.and
5.0%in France.Boeing isconcerned withthe volatileexchangeratebetweenthedollar andtheeuroandwould liketohedgeexchange exposure.a Itis consideringtwohedgingalternatives:selltheeuroproceedsfromthesale forwardor borroweurosfromtheCredit Lyonnaiseagainsttheeuro receivable.Which alternativewouldyourecommendWhyb Otherthings beingequal,at whatforwardexchangerate wouldBoeing beindifferent betweenthetwo hedgingmethodsSolution:a Inthecaseof forwardhedge,thefuturedollarproceedswillbe20,000,
0001.10=$22,000,
000.Inthecaseofmoney markethedge MMII,thefirmhas tofirst borrowthe PVofits euroreceivable,i.e.,20,000,000/
1.05=€19,047,
619.Thenthe firmshould exchangethis euroamount intodollars atthe currentspotrateto receive:€19,047,619$
1.05/€=$20,000,000,which canbe investedatthedollar interestratefor oneyear toyield:$20,000,
0001.06=$21,200,
000.Clearly,thefirmcan receive$800,000more byusing forwardhedging.b Accordingto IRP,F=Sl+i$/1+ii.Thus the“indifferent”forwardratewillbe:F=
1.
051.06/
1.05=$
1.06/€.
5.Suppose thatBaltimore Machinerysoldadrilling machinetoaSwiss firmand gavethe Swissclienta choiceof payingeither$10,000or SF15,000inthreemonths.a Inthe aboveexample,Baltimore Machineryeffectively gavethe Swissclient afree optiontobuy upto$10,000dollars usingSwissfranc.Whatisthe implied exercise exchangerateb Ifthespotexchangerateturns outtobe$
0.62/SF,which currencydo youthink the Swiss clientwillchoose touse forpayment Whatisthevalueof this freeoption forthe Swissclientc Whatisthebest wayfor BaltimoreMachinery todeal withtheexchangeexposureSolution:a Theimpliedexerciseprice rateis:10,000/15,
00030.6667/SF.二d IftheSwissclient choosesto pay$10,000,it willcost SF16,129=10,000/.62,Since theSwissclient hasan optiontopaySF15,000,itwillchoose todo so.The valueofthisoption isobviouslySF1,129=SF16,129-SF15,
000.e BaltimoreMachinery facesa contingentexposure inthe sensethat itmayormaynotreceiveSF15,000inthefuture.The firmthus canhedge thisexposure bybuying aputoptiononSF15,
000.
6.Princess CruiseCompany PCCpurchased aship fromMitsubishi HeavyIndustry.PCC owesMitsubishiHeavy Industry500million yeninoneyear.The currentspotrateis124yen perdollar andtheone-yearforward rateis110yen perdollar.The annualinterestrateis5%inJapanand8%intheU.S.PCCcan alsobuy aone-year calloptiononyen atthestrikepriceof$.0081per yenforapremiumof.014cents peryen.a Computethefuturedollar costsofmeetingthisobligationusing themoneymarkethedge。