Chapter 8

                   Problem 8.3 Hindustan Lever       Advise Hindustan Lever on its Japanese yen purchase.       Assumptions Values    180-day account payable, Japanese yen (¥) 8,500,000    Spot rate (¥/$) 120.60    Spot rate, rupees/dollar (Rs/$) 47.75    Implied (calculated) spot rate (¥/Rs) 2.5257 (120.60/47.75)    180-day forward rate (¥/Rs) 2.4000    Expected spot rate in 180 days (¥/Rs) 2.6000    180-day Indian rupee investing rate 8.000%    180-day Japanese yen investing rate 1.500%    Currency agent’s exchange rate fee 4.850%    Hindustan Lever’s cost of capital 12.00%    Spot Risk    Hedging Alternatives Values Rate (Rp/$) Assessment     

 1. Remain Uncovered, settling A/P in 180 days at spot rate  

     If spot rate in 180 days is same as current spot 3,365,464.34 2.5257 Risky       If spot rate in 180 days is same as forward rate 3,541,666.67 2.4000 Risky       If spot rate in 180 days is expected spot rate 3,269,230.77 2.6000 Risky       2. Buy Japanese yen forward 180 days       Settlement amount at forward rate (Rs) 3,541,666.67 2.4000 Certain  

   (Continued)

  Problem 8.3 Hindustan Lever (Continued)  

  3. Money Market Hedge    Principal A/P (¥) 8,500,000.00    discount factor for yen investing rate for 180 days 0.9926    Principal needed to meet A/P in 180 days (¥) 8,436,724.57       Current spot rate (¥/Rs) 2.5257    Indian rupee, current amount (Rs) 3,340,411.26    Hindustan Lever’s WACC carry-forwad factor for 180 days 1.0600    Future value of money market hedge (Rs) 3,540,835.94 Certain       4. Indian Currency Agent Hedge    Principal A/P (¥) 8,500,000.00    Current spot rate (¥/Rs) 2.5257    Current A/P (Rs) 3,365,464.34       Plus agent’s fee (4.850%) 163,225.02    Hindustan’s WACC carry-forwad factor for 180 days on fee 1.0600    Total future value of agent’s fee (Rs) 173,018.52       Total A/P, future value, A/P fee (Rs) 3,538,482.87 Certain       Evaluation of Alternatives                   The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.                   

               Problem 8.4 Mattel Toys       Advise Mattel on its European sales.    Assumptions Values  

  90-day A/R (€)€30,000,000.0

0    Current spot rate (4/€) $1.2186    Credit Suisse 90-day forward rate ($/€) $1.2170    Barclays 90-day forward rate ($/€) $1.2210    Expected spot rate in 90 days ($/€) $1.1800    90-day eurodollar interest rate 4.000%    90-day euro-euro interest rate 4.400%     Implied 90-day forward rate (calculated, $/€) $1.2174    90-day eurodollar borrowing rate 5.600%    90-day euro-euro borrowing rate 6.400%    Mattel Toys weighted average cost of capital ($) 9.600%    Risk    Hedging Alternatives Values Assessment    1. Remain Uncovered, settling A/R in 90 days at market rate    (20 million euros/future spot rate)    If spot rate in 90 days is same as current $36,558,000.00 Risky       If spot rate in 90 days is same as Credit Suisse forward rate $36,510,000.00 Risky       If spot rate in 90 days is same as Barclays forward rate $36,630,000.00 Risky       If spot rate in 90 days is expected spot rate $35,400,000.00 Risky    2. Sell euros forward 90 days    Settlement amount at Credit Suisse forward rate $36,510,000.00 Certain       Settlement amount at Barclays forward rate $36,630,000.00 Certain    3. Money Market Hedge  

  Principal A/R in euros€30,000,000.0

0  

  discount factor for euro borrowing rate for 90 days 0.98431/(1 (0.064

90/360))  

  Borrow euros against 90-day A/R€29,527,559.0

6    Current spot rate, $/euro $1.2186    US dollar current value $35,982,283.46    Mattel’s WACC carry-forward factor for 90 days 1.0240 1 (0.0960 90/360)       Future value of money market hedge $36,845,858.27 Certain  

  Evaluation of Alternatives          

 The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).  

             

               Problem 8.5 Tek: Italian account receivable       Hedging foreign exchange risk: a receivable  

  Assumptions Values  

  Account receivable due in 3 months, in euros (€)€4,000,000.0

0    Spot rate ($/(€) 1.2000    3-month forward rate ($/€) 1.2180    3-month euro interest rate 4.200%    3-month put option on euros:     Strike rate ($/€) 1.0800     Premium, percent per year 3.400%    Tek’s weighted average cost of capital 9.800%  

  a) b)    What are the costs and risk of each alternative? Value Certainty?       1. Do nothing and exchange euros for dollars at end of 3 months  

  Amount of euro receivable€4,000,000.0

0    If spot rate in 3 months is the same as the forward rate 1.2180 Very uncertain;    US dollar proceeds of receivable would be $4,872,000.00 Risky     

  Amount of euro receivable€4,000,000.0

0    If spot rate in 3 months is the same as the current spot rate 1.2000 Very uncertain;    US dollar proceeds of receivable would be $4,800,000.00 Risky  

  2. Sell euro receivable forward at the 3-month forward rate  

  Amount of euro receivable€4,000,000.0

0    forward rate 1.2180 Certain;    US dollar proceeds of receivable would be $4,872,000.00 Locked-in     

  Problem 8.5 Tek: Italian account receivable (Continued)  

  3. Buy a put option on euros  

  Amount of euro receivable€4,000,000.0

0    Current spot rate ($/euro) 1.2000    Premium on put option, % 3.400%    Cost of put option (amount spot rate percent premium) $163,200.00       If the spot rate at end of 3-months is less than strike rate Minimum is    the option is exercised yielding gross dollars of $4,320,000.00 guaranteed;    Less cost of option (premium) plus US$interest on premium $(167,198.40) could be    Net proceeds of A/R if option is exercised (this is Minimum) $4,152,801.60 greater.  

  Summary of Alternatives Value Certainty?    Do Nothing $4,800,000.00 Risky    Sell A/R forward $4,872,000.00 Certain    Buy Put Option $4,152,801.60 Minimum  

  c) If Tek wishes to play it safe, it should lock in the forward rate.  

 

d) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3-month period,past $1.20/€, then Tek might consider purchasing the put option on euros.

   

               Problem 8.6 Tek: Japanese account payable       Hedging foreign exchange risk: a payable       Assumptions Values    Account payable to Japan Sony-Tek, in Japanese yen (¥) 8,000,000.00    Spot rate (¥/$) 108.20    6-month forward rate (¥/$) 106.20    6-month yen deposit rate 1.250%    6-month dollar interest rate 4.000%    6-month call option on yen:     Strike rate (¥/$) 108.00     Premium, percent per year 2.500%    Tek’s weighted average cost of capital 9.800%       What are the costs and risk of each alternative? a) Value b) Certainty       1. Do nothing and exchange dollars for yen at end of 6 months    Amount of yen payable 8,000,000.00    If spot rate in 3 months is the same as the forward rate 106.20 Very uncertain;    US dollar cost of settling payable would be $75,329.57 Risky       Amount of yen payable 8,000,000.00    If spot rate in 3 months is the same as the current spot rate 108.20 Very uncertain;    US dollar cost of settling payable would be $73,937.15 Risky       2. Buy yen forward 6-months to lock in cost of settling payable    Amount of yen payable 8,000,000.00    forward rate 106.20 Certain;    US dollar cost of settling payable would be $75,329.57 Locked-in     

  Problem 8.6 Tek: Japanese account payable (Continued)  

  3. Money market hedge—invest funds in yen deposit now  

     Principal needed at the end of 6-months, yen 8,000,000    Discount factor, 6-months @ yen deposit rate 0.9938 1/(1 (0.0125 180/360))    Yen deposit needed, now 7,950,311    Current spot rate (¥/$) 108.20    US dollars needed now, for exchange into yen $73,477.92    Carry-forward rate, 6 months @ Tek’s WACC 1.05 1 (0.0980 180/360)    US cost of money market hedge at end of 6-months $77,078.33       4. Buy a call option on Japanese yen    Amount of yen payable 8,000,000.00    Current spot rate (¥/$) 108.20    Premium on call option, % 2.500%    Cost of call option $1,848.43       If the spot rate at end of 3-months is greater than strike rate Maximum cost    the option is exercised yielding gross dollars of $74,074.07 guaranteed;    Plus cost of option (premium) plus US$interest on premium $1,939.00 could be    Total cost of exercising call option on yen $76,013.08 less.       Summary of Alternatives: Cost of settling A/P Value Certainty?    Do Nothing $73,937.15 Risky    Buy yen forward $75,329.57 Certain    Deposit yen now (money market hedge) $77,078.33 Certain    Buy call option on yen $76,013.08 Maximum       c) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view

that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere below the option strike rate of ¥108/$, then Tek might consider purchasing the call option. If Tek is a bit more risk adverse, the forward rate is relatively attractive compared to the money market hedge.

                       

               Problem 8.7 Tek: British Telecom bidding       Hedging foreign exchange risk of a contract bid       Assumptions Values    Account receivable of bid, supply & install (British pounds, £) £1,500,000    Spot rate ($/£) 1.8418    Tek’s weighted average cost of capital 9.800%       1-month 4-month    Forward rate ($/£) 1.8368 1.8268    British pound investment rate 4.000% 4.125%    British pound borrowing rate 6.500% 6.500%    Put option on pound:     Strike rate ($/£) 1.85 1.85     Premium ($/£) $0.006 $0.012       Analysis and Evaluation a) Value b) Certainty     

 If Tek wins the bid, it will be long foreign currency, having a 1.5 million  

  pound position which is first backlog then an A/R.       If and when Tek is awarded the bid, it would have 4 months (120 days)    until cash settlement of the 1 million pound position.    1. Do Nothing—Remaining Uncovered    Wait 120 days and exchange pounds for dollars spot    If the ending spot rate is the same as current spot rate $2,762,700.00 Risky       If the ending spot rate is the same as the 4-month forward rate $2,740,200.00 Risky    It could, however, be much lower.     

  2. Sell the pounds forward    Selling 1 million pounds forward at the 4-month forward rate $2,740,200.00 Certain Value    The primary problem with this is that if Tek does not win the bid, If Tek Wins Bid    it has a forward contract to sell pounds which it will not earn.       3. Money market hedge—borrow against expected receipts    Expected receipts (£) £1,500,000  

  Discount factor for 4-months at pound borrowing rate 0.97881/(1 (0.065

120/360))    Proceeds from borrowing, now (£) £1,468,189    Current spot rate ($/£) 1.8418    Proceeds from borrowing, now ($) $2,704,110.93    Carry-forward rate, 4 months @ Tek’s WACC 1.0327 1 (0.098 120/360)    Value in 4 months of money market hedge ($) $2,792,445.22       4. Buy a put option on pounds at strike price of 1.85    Option, if exercised (if ending spot rate less than $1.85) $2,775,000.00       Put option premium, up-front $18,000.00    and the 4-months opportunity cost of premium 588.00    Total premium expense $18,588.00    Minimum;    Minimum dollars received if put option purchased $2,756,412.00 Could be More       The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid’s award.

The advantage of the option is if Tek does not win the bid, the option can easily be sold. 

                

               Problem 8.8 Tek—Swedish price list       Hedging foreign currency price quotes and potential sales.       Assumptions Values    Expected sale over 90-day period, Swedish krona (SKr) 5,000,000.00 Could be more    Spot rate (SKr/$) 7.4793    90-day forward rate (SKr/$) 7.4937    3-month dollar interest rate 4.000%    3-month krona deposit interest rate 4.780%    3-month krona borrowing interest rate 6.500%    3-month put option on krona:     Strike rate (SKr/$) 7.50     Premium 2.500%    Tek’s weighted average cost of capital 9.800%       Hedging Alternatives    This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of  sales will occur, and therefore what Tek’s actual long position in Swedish krona will be.    Value Certainty?    1. Do Nothing—Remain Uncovered.    The ending spot rate at the time of settlement    could be nearly anything.    If the ending spot rate is the same as current spot rate (SKr/$) $668,511.76 Risky       If the ending spot rate is the same as forward (SKr/$) $667,227.14 Risky       2. Sell Swedish krona forward       Sold forward 3-months at forward rate (SKr/$) $667,227.14 Certain    However, remember that Tek does not know total sales.     

  Problem 8.8 Tek—Swedish price list (Continued)  

  3. Money market hedge     Tek would borrow now against expected proceeds of (SKr) 5,000,000.00    Discount rate of SKr interest rate for 90-days 0.98401    SKr proceeds from borrowing received up-front 4,920,049.20    Exchanged at current spot rate (SKr/$) 7.48    US dollars received now $657,822.15    Tek carry-forward rate for US$for 90 days 1.025    Money market hedge proceeds in 90-days $673,938.79       4. Buy a 3-month put option on Swedish krona If exercised If not exercised     Proceeds will be option less premium if exercised (minimum) (random choice)    Exchange rate if exercised/not exercised (SKr/$) 7.50 7.24    Amount of Swedish krona 5,000,000.00 5,000,000.00    If exercised, it will yield a gross dollar amount of $666,666.67 $690,607.73       Put option premium $16,712.79 $16,712.79    Opportunity cost of premium 409.46 409.46    Total future value of premium $17,122.26 $17,122.26       Minimum net dollar proceeds at end of 90 days $649,544.41 $673,485.48    (exercised gross amount less future value of premium) Minimum       The money market hedge provides the highest certain US dollar receipts. (This is again a result of the

significant increase in relative value arising from carrying-forward the dollars at Tek’s WACC.) 

        If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr

would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the same amount of US dollars as the money market hedge.

                    

               Problem 8.9 Tek: Swiss dividend payable       Hedging an intra-company dividend payment.       Assumptions Values    Dividend declared, Swiss francs (SFr) SFr. 5,000,000    Spot rate (SFr/$) 1.2462    90-day forward rate (SFr/$) 1.2429    3-month US dollar interest rate 4.000%    3-month Swiss franc interest rate 3.750%    3-month put option on Swiss francs:     Strike rate (SFr/$) 1.25     Premium ($/SFr) $0.015    Tek’s weighted average cost of capital 9.80%    Tek’s expected spot rate in 90 days (SFr/$) 1.22       Hedging Alternatives Value Certainty?       1. Do Nothing—Remain Uncovered.       If the ending spot rate is the same as current spot rate (SFr/$) $4,012,197.08 Risky       If the ending spot rate is the same as forward (SKr/$) $4,022,849.79 Risky       Realistically, the ending spot rate could vary between SFr1 and SFr2 per $.       2. Sell Swiss francs forward       Sold forward 3-months at forward rate (SFr/$) $4,022,849.79 Certain     

  Problem 8.9 Tek: Swiss dividend payable (Continued)  

  3. Money Market Hedge    Borrow SFr now against future receipt    Principal SFr. 5,000,000    Borrow SFr at SFr interest rate for 90-days 0.9907    SFr proceeds received now via borrowing SFr. 4,953,560    Exchanged into US$at spot rate of (SFr/$) 1.25    Dollars received now $3,974,932.09    Carry-forward rate for US$at Tek’s WACC for 90-days 1.0245    Money Market Hedged proceeds in 90 days $4,072,317.93       4. Buy a 3-month put option on Swiss francs If exercised If not exercised       Proceeds option – premium, if exercised (minimum)    Effective exchange rate if exercised/not exercised, SFr/$ 1.25 1.22    Principal of payment, SFr SFr. 5,000,000 SFr. 5,000,000    If exercised, it will yield a gross dollar amount of $4,000,000.00 $4,098,360.66       Put option premium $75,000.00 $75,000.00    Opportunity cost of premium 1,837.50 1,837.50    Total future value of premium $76,837.50 $76,837.50       Minimum net dollar proceeds at end of 90 days $3,923,162.50 $4,021,523.16    (exercised gross amount less future value of premium) Minimum       Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however,

Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.20/$or stronger to end up superior to the Money Market Hedge.)

       

                

                   Problem 8.10 Northern Rainwear       Hedging foreign exchange risk: A/R & forward points  

  Assumptions ValuesForwardDiscount  

  Spot rate, DKr/C$ 4.70    3-month forward rate, DKr/C$ 4.71 –0.85%    6-month forward rate, DKr/C$ 4.72 –0.85%    12-month forward rate, DKr/C$ 4.74 –0.84%  

  Northern’s Exposures 0–90 days 91–180 days > 180 days    A/R due in 3 months, DKr 3,000,000    A/R due in 6 months, DKr 2,000,000    A/R due in 12-months, DKr 1,000,000       Northern’s Manadatory Forward Cover 0–90 days 91–180 days > 180 days    Paying the points forward 75% 60% 50%    Receiving the points forward 100% 90% 50%    Analysis & Exposure Management                The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$forward.    Northern Rainwear is receiving foreign currency, DKr, at future dates (“long DKr”).    Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD.    Required Forward Cover for Northern: 0–90 days 91–180 days > 180 days    A/R due in 3 months, DKr 75%    A/R due in 6 months, DKr 60%    A/R due in 12-months, DKr 50%    DKr Forward Cover    A/R due in 3 months, DKr 2,250,000    A/R due in 6 months, DKr 1,200,000    A/R due in 12-months, DKr         500,000    Expected Canadian dollar value of DKr sold forward 477,707.01 254,237.29 105,485.23  

               Problem 8.11 Vamo Road Industries       Hedging foreign exchange risk: a payable  

  Assumptions Values    Construction payment due in six-months (A/P, quetzals) 8,400,000    Present spot rate (quetzals/$) 7.0000    Six-month forward rate (quetzals/$) 7.1000    Guatemalan six-month interest rate (per annum) 14.000%    U.S. dollar six-month interest rate (per annum) 6.000%    Vamo’s weighted average cost of capital (WACC) 20.000%    Expected spot rate in six-months (quetzals/$):     Highest expected rate 8.0000     Expected rate 7.3000     Lowest expected rate 6.4000  

  a) What realistic alternatives are available to Vamo? Cost Certainty    1. Wait six months and make payment at spot rate       Highest expected rate $1,050,000.00 Risky       Expected rate $1,150,684.93 Risky       Lowest expected rate $1,312,500.00 Risky       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    Cost in dollars today (quetzals to $at spot rate) $1,121,495.33    factor to carry dollars forward 180 days (1 (WACC/2)) 1.10    Cost in dollars in six-months ($carried forward 180 days ) $1,233,644.86 Certain  

 The second choice, the forward contract, results in the lowest cost alternative amongcertain alternatives.  

               Problem 8.12 Worldwide Travel’s acquisition       Hedging foreign exchange risk: a payable       Assumptions Values    Acquisition price & 3-month A/P, NewTaiwan dollars (T$) 7,000,000    Spot rate (T$/$) 33.40    3-month forward rate (T$/$) 32.40    3-month Taiwan dollar deposit rate 1.500%    3-month dollar borrowing rate 6.500%    3-month call option on T$ not available       Evaluation of Alternatives Cost Certainty       1. Do Nothing—Wait 3 months and buy T$spot       If spot rate is the same as current spot rate $209,580.84 Risky       If spot rate is the same as 3-month forward rate $216,049.38 Risky       Although this would do nothing to cover the currency risk,    there would be no required payment or borrowing for 3-months.       2. Buy T$forward 3-months       Assured cost of T$at 3-month forward rate $216,049.38 Certain       The purchase of a forward contract would not require any cash    up-front, but the Bank of Hawaii would reduce his available credit    line by the amount of the forward. This is a non-cash expense.    3. Money Market Hedge: Exchanging US$for T$now, depositing for 3-months until payment     Acquisition price in T$needed in 3-months 7,000,000    Discounted back 3-months at T$deposit rate 0.9963    Amount of NT$needed now for deposit 6,973,848    Spot rate, T$/$ 33.40    US$needed now for exchange $208,797.85       US$carry-forward rate (3-month dollar borrowing rate) 6.500% Certain    Carry-forward factor of US$for 3-month period 1.0163    Total cost in US$of settling A/P in 3-months with $212,190.81    Money Market Hedge       The currency risk is eliminated, but since Matt Morita would have to exchange the money up-

front, it requires Matt Morita to increase his debt outstanding for the entire 3 months. 

     Forward contract hedge is probably the best “acceptable” alternative.               

           Problem 8.13 Seattle Scientific, Inc.       Costs and benefits of cash versus cover.       Assumptions Values    Seattle’s 30-day account receivable, Japanese yen 12,500,000    Spot rate, yen/$ 120.23    30-day forward rate, yen/$ 119.73    90-day forwrad rate, yen/$ 118.78    180-day forward rate, yen/$ 117.21    Yokasa’s WACC 8.850%    Seattle Scientific’s WACC 12.500%    Desired discount on purchase price by Yokasa 4.500%       Josh Miller should compare two basic alternatives, both of which eliminate the currency risk.     1. Allow the discount and receive payment in Japanese yen in cash       Account recievable (yen) 12,500,000    Discount for cash payment up-front (4.500%) (562,500)    Amount paid in cash net of discount 11,937,500       Current spot rate 120.23    Amount received in U.S. dollars by Seattle Scientific $99,288.86       2. Not offer any discounts for early payment and cover exposure with forwards       Account receivable (yen) 12,500,000    30-day forward rate 119.73    Amount received in cash in dollars, in 30 days $104,401.57       Discount factor for 30 days @ Seattle’s WACC 0.9897    Present value of dollar cash received $103,325.27       Josh Miller should politely decline Yokasa’s offer to pay cash in exchange for cash payment.            

               Problem 8.14 Wilmington Chemical Company       Hedging foreign exchange risk: a payable       Assumptions Values    Shipment of phosphates from Morocco, Moroccan dirhams 6,000,000    Wilmington’s cost of capital (WACC) 14.000%    Spot exchange rate, dirhams/$ 10.00    Six-month forward rate, dirhams/$ 10.40       Options on Moroccan dirhams: Call Option Put Option    Strike price, dirhams/$ 10.00 10.00    Option premium (percent) 2.000% 3.000%       United States Morocco    Six-month interest rate for borrowing (per annum) 6.000% 8.000%    Six-month interest rate for investing (per annum) 5.000% 7.000%       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    Possible spot rate in six months—the current spot rate (dirhams/$) 10.00    Cost of settlement in six months (US$) $600,000.00 Uncertain.       Account payable (dirhams) 6,000,000    Possible spot rate in six months—forward rate (dirhams/$) 10.40    Cost of settlement in six months (US$) $576,923.08 Uncertain.     

  Problem 8.14 Wilmington Chemical Company (Continued)  

  2. Forward market hedge. Buy dirhams forward six months.       Account payable (dirhams) 6,000,000    Six month forward rate, dirhams/$ 10.40    Cost of settlement in six months (US$) $576,923.08 Certain.       3. Money market hedge. Exchange dollars for dirhams now, invest for six months.    Account payable (dirhams) 6,000,000.00    Discount factor at the dirham investing rate for 6 months 1.035    Dirhams needed now for investing (payable/discount factor) 5,797,101.45    Current spot rate (dirhams/$) 10.00    US dollars needed now $579,710.14    Carry forward rate for six months (WACC) 1.070    US dollar cost, in six months, of settlement $620,289.86 Certain.       4. Call option hedge. (Need to buy dirhams call on dirhams)    Option principal 6,000,000.00    Current spot rate, dirhams/$ 10.00    Premium cost of option 2.000%    Option premium (principal/spot rate % pm) $12,000.00       If option exercised, dollar cost at strike price of 10.00 dirhams/$ $600,000.00    Plus premium carried forward six months (pm 1.07, WACC) 12,840.000    Total net cost of call option hedge if exercised $612,840.00 Maximum.     

 The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to depreciate significantly over the next six months, it may choose the call option.  

             

               Problem 8.15 Dawg-Grip, Inc.       Hedging foreign exchange risk: a payable       Assumptions Values    Purchase price of Korean manufacturer, in Korean won 7,030,000,000    Less initial payment, in Korean won (1,000,000,000)    Net settlement needed, in Korean won, in six months 6,030,000,000    Current spot rate (Won/$) 1,200    Six month forward rate (Won/$) 1,260    Plasti-Grip’s cost of capital (WACC) 25.00%       Options on Korean won: Call Option Put Option    Strike price, won 1,200.00 1,200.00    Option premium (percent) 3.000% 2.400%       United States Korea    Six-month investment interest rate (per annum) 4.000% 16.000%    Six-month borrowing rate (investment rate 2%) 6.000% 18.000%       Risk Management Alternatives Values Certainty       1. Remain uncovered, making the won payment in 6 months    at the spot rate in effect at that date    Account payable (won) 6,030,000,000    Possible spot rate in six months: current spot rate (won/$) 1,200    Cost of settlement in six months (US$) $5,025,000.00 Uncertain.       Account payable (won) 6,030,000,000    Possible spot rate in six months: forward rate (won/$) 1,260    Cost of settlement in six months (US$) $4,785,714.29 Uncertain.  

  Problem 8.15 Dawg-Grip, Inc. (Continued)  

  2. Forward market hedge. Buy won forward six months       Account payable (won) 6,030,000,000    Forward rate (won/$) 1,260.00    Cost of settlement in six months (US$) $4,785,714.29 Certain.       3. Money market hedge. Exchange dollars for won now, invest for six months.    Account payable (won) 6,030,000,000    Discount factor at the won interest rate for 6 months 1.080    Won needed now (payable/discount factor) 5,583,333,333.33    Current spot rate (won/$) 1,200.00    US dollars needed now $4,652,777.78    Carry forward rate for six months (WACC) 1.125    US dollar cost, in six months, of settlement $5,234,375.00 Certain.       4. Call option hedge. (Need to buy won call on won) If exercised If not exercised    Option principal 6,030,000,000    Current spot rate (won/$) 1,200.00 1,307.00    Premium cost of option (%) 3.000%    Option premium (principal/spot rate % pm) $150,750.00       If option exercised/not exercised, dollar cost of won $5,025,000.00 $4,613,618.97    Premium carried forward six months (pm 1.125, WACC) 169,593.750 169,593.75    Total net cost of call option hedge if exercised $5,194,593.75 $4,783,212.72    Maximum.       The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes    the ending spot rate will be Won 1307/$or higher, the call option hedge could prove lower cost. This would require the    firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event    their spot rate expectations proved incorrect.               

               Problem 8.16 Aqua-Pure       Hedging foreign exchange risk: a receivable       Assumptions Values    Amount of receivable, Japanese yen 20,000,000    Spot exchange rate at time of sale (yen/$) 118.255     Booked value of sale (amount/spot rate) $169,126.04    Days receivable due 90    Aqua-Pure’s WACC 16.0%    Competitor borrowing premium, yen 2.0%       Forward rates and premiums Forward Rate Premium    One-month forward rate (yen/$) 117.760 5.04%    Three-month forward rate (yen/$) 116.830 4.88%    One-year forward rate (yen/$) 112.450 5.16%       Investment rates, % per annum United States Japan    1 month 4.8750% 0.09375%    3 months 4.9375% 0.09375%    12 months 5.1875% 0.31250%       Purchased options Strike (yen/$) Premium    3-month call option on yen 118.000 1.0%    3-month put option on yen 118.000 3.0%     

  Problem 8.16 Aqua-Pure (Continued)  

  a. Alternative Hedges Values Certainty       1. Remain uncovered.    Account receivable (yen) 20,000,000    Possible spot rate in 90 days (yen/$) 118.255    Cash settlement in 90 days (US$) $169,126.04 Uncertain.    2. Forward market hedge.    Account receivable (yen) 20,000,000    Forward rate (won/$) 116.830    Cash settlement in 90 days (US$) $171,188.91 Certain.    3. Money market hedge.    Account receivable (yen) 20,000,000  

  Discount factor for 90 days 1.005231 ((0.0009375 .02)

90/360)    Yen proceeds up front 19,895,858    Current spot rate (won/$) 118.255    US dollars received now $168,245.38    Carry forward at Aqua-Pure’s WACC 1.0400 1 (0.16 90/360)    Proceeds in 90 days $174,975.20 Certain.  

 4. Put option hedge. (Need to sell yen put on yen)  

  Option principal 20,000,000    Current spot rate (won/$) 118.255    Premium cost of option (%) 3.000%    Option pm (principal/spot rate % pm) $5,073.78    If option exercised, dollar proceeds $169,491.53    Less Pm carried forward 90 days (5,276.732) 1.04 carry-forward rate    Net proceeds in 90 days $164,214.79 Minimum.  

  The put option does not GUARANTEE the company of settling for the booked amount.    The money market and forward hedges do; the money market yielding the higher proceeds.  

 b) Breakeven rate between the money market and the forward hedge is determined by the

reinvestment rate:    Money market, US$up-front $168,245.38    Forward contract, US$, end of 90 days $171,188.91    (1 x) 101.750% $168,245 (1 x) $171,189    x 1.74954% For 90 days    Breakeven rate, % per annum 6.998%  

               Problem 8.17 Botox Watch Company    Hedging policy  

  Assumptions Values    Account recievable in 90 days (€) 1,560,000    Initial spot exchange rate ($/€) $1.2340    Forward rate, 90 days ($/€) $1.2460    Expected spot rate in 90 to 120 days ($/€): Case #1 $1.2000    Expected spot rate in 90 to 120 days ($/€): Case #2 $1.2600  

  Hedged Hedged    If Botox Watch Company …… the Minimum the Maximum    Proportion of exposure to be hedged 70% 120%    Total exposure (€) 1,560,000 1,560,000    hedged proportion 70% 120%    Minimum hedge in euros (exposure min prop) 1,092,000 1,872,000    at the forward rate ($/€) $1.2460 $1.2460    locking in ($) $1,360,632 $2,332,512  

  Case #1: Ending spot rate    Proportion uncovered (short) 468,000 (312,000)    If ending spot rate is ($/€) $1.2000 $1.2000    Value of uncovered proportion ($) $561,600 $(374,400)  

  Value of covered proportion (from above) $1,360,632 $2,332,512    Total net proceeds, covered uncovered $1,922,232 $1,958,112  

  Case #2: Ending spot rate    Proportion uncovered (short) 468,000 (312,000)    If ending spot rate is ($/€) $1.2600 $1.2600    value of uncovered proportion ($) $589,680 $(393,120)  

  Value of covered position (from above) $1,360,632 $2,332,512    Total net proceeds, covered uncovered $1,950,312 $1,939,392  

  Benchmark: Full (100%) forward cover $1,943,760 $1,943,760    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.

       

                   Problem 8.18 Redwall Pump Company       Hedging foreign exchange risk: a receivable       Assumptions Values Today is March 1        90-day Forward rate, $/euro $1.1060   Exchange Rate    180-day Forward rate, $/euro $1.1130 Date ($/euro)    US Treasury bill rate 3.600% February 1 $1.0800  

 Redwall’s borrowing rate, euros, per annum 8.000% March 1   $1.1000  

  Redwall’s cost of equity 12.000%       Options on euros Strike ($/euro) Call Option Put Option    June maturity options $1.1000 3.0% 2.0%    September maturity options $1.1000 2.6% 1.2%     

  Valuation of Alternative Hedges June ReceivableSept

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    Respective forward rates ($/euro) $1.1060 $1.1130    US dollar proceeds as hedged ($) $2,212,000 $2,226,000    Carry forward to Sept 1st at WACC 1.03 —    Total US$proceeds on Sept 1st $2,278,360 $2,226,000    Total of both payments $4,504,360     

(Continued)

  Problem 8.18 Redwall Pump Company (Continued)  

  b. Hedge in the money market    Amount of receivable, in euros €2,000,000 €2,000,000    Discount factor for euro funds, period 1.02 1.04    Current proceeds from discounting, euros €1,960,784 €1,923,077    Current spot rate ($/euro) $1.1000 $1.1000    Current US dollar proceeds $2,156,863 $2,115,385    Carry forward rate for the period 1.06 1.06    US dollar proceeds on future date $2,286,275 $2,242,308    Total of both payments $4,528,582       c. Hedge with options    Amount of receivable, in euros €2,000,000 €2,000,000    Buy put options for maturities (% spot value) $(44,000) $(26,400)    Carry forward for the period 1.06 1.06    Premium cost carried forward to Sept 1 $(46,640) $(27,984)       Gross put option value if exercised $2,200,000 $2,200,000    Carried forward 3 months to Sept 1 1.03 —    Gross proceeds, Sept 1 $2,266,000 $2,200,000    Total net proceeds, after premium deduction, Sept 1 $4,391,376  

  d. Do nothing (remain uncovered)    Amount of receivable, in euros €2,000,000 €2,000,000    Ending spot exchange rate ($/euro) ??? ???       The money market hedge provides the highest certain outcome.    If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to    take the currency risk, the put option hedges could be considered.  

ance, Second Edition

                 

                       Problem 8.19 Pixel’s financial metrics       Transaction exposure life-span and accounting treatment.    Days Forward    Date Event Spot Rate Forward Rate of Forward Rate       February 1 Price quotation by Metrica 1.7850 1.7771 210    March 1 Contract signed for sale 1.7465 1.7381 180    Contract amount, pounds £1,000,000    June 1 Product shipped to Grand Met 1.7689 1.7602 90    August 1 Product received by Grand Met 1.7840 1.7811 30    September 1 Grand Met makes payment 1.7290 — —       Analysis                       a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, 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).       Value as settled 1 million pounds @ $1.7290/pound $1,729,000    Value as booked 1 million pounds @ $1.7689/pound $1,768,900    FX gain (loss) $(39,900)       b. The vlaue of the foreign exchange gain (loss) will depend upon when Leo 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.     

(Continued)

  Problem 8.19 Pixel’s financial metrics (Continuted)  

  Forward contract purchased on June 1    Value of forward settlement 1 million pounds @ $1.7602/pound $1,760,200    Value as booked 1 million pounds @ $1.7689/pound $1,768,900    FX gain (loss) $(8,700)       A more aggressive alternative is for Leo to purchase the forward contract on the date that the contract was signed, March 1, locking-  

 in Pixel’s US dollar settlement amount a full 90 days earlier in the transaction exposure’s life span.  

     Forward contract purchased on March 1    Value of forward settlement 1 million pounds @ $1.7381/pound $1,738,100    Value as booked 1 million pounds @ $1.7689/pound $1,768,900    FX gain (loss) $(30,800)       Note that in this case if Leo had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would    have been even greater, although “fully hedged.” The difference is of course the result of the forward rate changing with spot rates    and interest differentials.                       

           

 

  Problem 8.20 Maria Gonzalez and Trident (A)            Assumptions Value    90-day A/R in pounds 3,000,000    Spot rate, US$per pound 1.7620    90-day forward rate, US$per pound 1.7550    3-month U.S. dollar investment rate 6.000%    3-month U.S. dollar borrowing rate 8.000%    3-month UK investment interest rate 8.000%    3-month UK borrowing interest rate 14.000%    Put options on the British pound: Strike rates, US$/pound 1.75 1.71     Put option premium 1.500% 1.000%    Trident’s WACC 12.000%    Maria Gonzalez’s expected spot rate in 90-days, US$per pound 1.7850    Alternative #1: Remain Uncovered   Rate ($/pound)   Proceeds  

 Value of A/R will be (3 million pounds ending spot rate ($/pound))  

  If spot rate is the same as current spot rate $1.7620 $5,286,000.00    If ending spot rate is the same as current forward rate $1.7550 $5,265,000.00    If ending spot rate is the expected spot rate $1.7850 $5,355,000.00    Alternative #2: Forward Contract Hedge   Rate ($/pound)   Proceeds    Sell the pounds forward 3-months locking in the forward rate    Pound A/R at the forward rate (pounds forward) $1.7550 $5,265,000.00  

  Alternative #3: Money Market Hedge   Rate ($/pound)   Proceeds    Trident borrows against the A/R, receiving pounds up-front, exchanging into US$.    Amount of A/R in 90-days, in pounds 3,000,000.00    Discount factor, pound borrowing rate, for 3-months 0.9662    Proceeds of borrowing, up-front, in pounds 2,898,550.72    Exchanged to US$at current spot rate of $1.7620    US$received against A/R, up-front $5,107,246.38    US$need to be carried forward for comparison:    Carry-forward rate, WACC for 90-days 1.0300    Money Market Hedge, US$, at end of 90-days $5,260,463.77  

(Continued)  

  Problem 8.20 Maria Gonzalez and Trident (A) (Continued)          

Strike Rate ($/pnd)

Strike Rate ($/pnd)

  Alternative #4: Put Option Hedges   1.75   1.71    Option premium 1.500% 1.000%    Notional principal of option (pounds) 3,000,000 3,000,000    Spot rate ($/pound) 1.7620 1.7620    Option premium, US$ $79,290.00 $52,860.00    Carry-forward factor, WACC, for 90-days 1.0300 1.0300    Total premium cost, in 90-days $81,668.70 $54,445.80       Proceeds from put option if exercised $5,250,000.00 $5,130,000.00    Less cost of premium, including time-value (81,668.70) (54,445.80)    Net proceeds from put options, in 90-days: Minimum $5,168,331.30 $5,075,554.20  

  Ending spot rate needed to be superior to forward: $1.7825 $1.7732    Proceeds from exchanging pounds for US$spot $5,347,500.00 $5,319,600.00    Less cost of option (allowed to expire OTM) (81,668.70) (54,445.80)    Net proceeds from put option, unexercised $5,265,831.30 $5,265,154.20  

  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; the $1.71 strike price would be superior to the forward if the ending spot rate were $1.7732 or higher.

                          

                           Problem 8.21 Maria Gonzalez and Trident (B)                         Construction of Trident’s income statement, with foreign exchange losses and EPS by strategy.       Exchange Rate Assumptions Assumption Assumption Assumption Part c) Positions    Spot exchange rates at booking:    US dollars per euro 1.0560 1.0560 1.0560    US dollars per pound 1.5900 1.5900 1.5900    Japanese yen per dollar 122.43 122.43 122.43    90-day forward rates:    US dollars per euro 1.0250 1.0250 1.0250 Paying points    US dollars per pound 1.5875 1.5875 1.5875 Paying points    Japanese yen per dollar 120.85 120.85 120.85 Receiving points    Spot rate forecasts:    US dollars per euro 1.0660 1.0660 1.0660    US dollars per pound 1.5600 1.5600 1.5600    Japanese yen per dollar 126.00 126.00 126.00    Settlement spot rates:    US dollars per euro — — 1.0480    US dollars per pound — — 1.6000    Japanese yen per dollar — — 122.50    Export sales in currency of invoice:    Sales in European euros €2,340,000 €2,340,000 €2,340,000 50% Fwd Cover    Sales in British pounds £1,780,000 £1,780,000 £1,780,000 50% Fwd Cover    Sales in Japanese yen 125,000,000 125,000,000 125,000,000 100% Fwd Cover    a) b) c)    FX gains (losses) by sale: Settled at Forecast Settled at Forward Forwards on Points    Sales in European euros $23,400 $(72,540) $(45,630)    Sales in British pounds $(53,400) $(4,450) $6,67    Sales in Japanese yen $(28,928) $13,349 $13,34    $(58,928) $(63,641) $(25,606)  

(Continued)

                     

     Problem 8.21 Maria Gonzalez and Trident (B) (Continued)            

  Uncovered 100% Forward Forward Cover    Income Statement (US$) Settled at Forecast Cover Based on Points    Sales $13,622,232 $13,622,232 $13,622,232     Domestic sales 7,300,000 7,300,000 7,300,000     Export sales 6,322,232 6,322,232 6,322,232    Less cost of goods sold 65% (8,854,451) (8,854,451) (8,854,451)    Gross profit $4,767,781 $4,767,781 $4,767,781       Less G&A expenses 9% (1,226,001) (1,226,001) (1,226,001)    Less depreciation (248,750) (248,750) (248,750)    Foreign exchange gains (losses) (58,928) (63,641) (25,606)    EBIT $3,234,102 $3,229,389 $3,267,424       Less US corporate taxes 40% (1,293,641) (1,291,755) (1,306,969)    Net income $1,940,461 $1,937,633 $1,960,454       Shares outstanding 1,000,000 1,000,000 1,000,000    Earnings per share (EPS) $1.940 $1.938 $1.960     

 

Trident’s EPS is highest in part c), where it determined its forward cover by whether it would receive or pay the forward points. In part c), for both the euro and the pound, Dayton is paying the points, and would therefore decide to cover 50% of the exposure with forwards (the yen is receiving the points, and is 100% covered with forwards). The foreign exchange loss for the pound is smaller in part c) because the pound moved in the company’s favor. Although the euro moves against the firm, the loss is not as large as what would occur under the forward contract.  

                         

           Problem 8.22 Siam Cement           Assumptions Value    US dollar debt taken out in June 1997 $50,000,000    US dollar borrowing rate on debt 8.400%    Initial spot exchange rate, baht/dollar, June 1997 25.00    Average spot exchange rate, baht/dollar, June 1998 42.00       Calculation of Foreign Exhange Loss on Repayment of Loan     

 At the time the loan was acquired, the scheduled repayment of dollar  

  and baht amounts would have been as follows:       Scheduled Repayment:    Repayment of US dollar debt: Principal $50,000,000    Repayment of US dollar debt: Interest 4,200,000     Total repayment $54,200,000       Exchange rate at time of repayment, baht/dollar 25.00     Total repayment in Thai baht 1,355,000,000     Total proceeds from loan, up-front, in Thai baht 1,250,000,000     Net interest to be paid, in Thai baht 105,000,000       Actual Repayment:    Repayment of US dollar debt: Principal $50,000,000    Repayment of US dollar debt: Interest 4,200,000     Total repayment $54,200,000       Exchange rate at time of repayment, baht/dollar 42.00     Total repayment in Thai baht 2,276,400,000     Less what Siam had EXPECTED or SCHEDULED to be repaid (1,355,000,000)    Amount of foreign exchange loss on debt 921,400,000