Finance International Problemset 3 Hedging & Transaction Exposure 1. Suppose that you will be paid 6,000,000 Pakistani Rupees (PR) in one year, but are concerned that Pakistan and Afghanistan will go to war. The revenues are certain. The current spot is 59.5PR/$ and you can obtain a six month loan from a Pakistani bank at for 12%. There are no derivatives or forwards available on the PR. How can you hedge, and what are the cash-flows? Use a money market hedge. Borrow the PV of 6,000,000 PR and use the revenues to pay of the loan. You will receive today: 6,000,000 RP 59.5RP / $ = $90,036 1.12 2. Continuing from question 1. Suppose that 1-Year PR futures are available on the National Stock Exchange of India for a price of 1.500PR/IR (Indian Rupee) with each contract controlling 100,000 PR. If the one year forward on Indian Rupees is 38IR/$, and you can earn 5% on invested fund in the US, should you stick with the money market hedge in 2, or should you hedge through the Indian Rupee? Hedging through the Indian Rupee will require two transactions: Selling 60 PR future contracts Selling the equivalent amount in IR forward At a contract price of 1.5PR/IR, you will receive 4,000,000 IR in one year. Selling the IR forward at 38 IR/$ will yield $105,263. To compare with the money market hedge, we must move the cash-flows to the same point in time. $105,263 = $100,251 1.05 Thus, barring additional risk from not extracting our profits today, hedging through the Indian Rupee is superior. 3. Again referring to problem 1. Suppose that the PR is highly correlated with the Indonesian Rupiah (its not, but that's what we'll assume). If the one year forward on the Rupiah is 9520 RP/$, how would you cross-hedge using this currency? How about using 1-year futures contracts on the US dollar, sold on the Jakarta Exchange at 9500 RP/$? Assume that the current spot on the RP is 9200 RP/$, and that each dollar contract controls $10,000. Since the spot on the PR is 59.5 PR/$, the current spot between the Rupee and Rupiah is: 9200 RP / $ = 154.62 RP / PR 59.5 PR / $
International Finance Problemset 3
If the currencies are highly correlated, that ratio should roughly hold. Thus, we will need to sell forward: 154.62 RP / PR 6,000,000 PR = 927,720,000 RP Since each futures contract controls $10,000, the current cost is 95,000,000RP. To cross-hedge, we treat the PR revenue as if it were a RP revenue. Because contracts at the Indonesian exchange are for US Dollars, BUYING THE DOLLAR is the same thing as SELLING THE RP (which is like selling PR). Thus we need to sell 927,720,000 RP 95,000,000 = 9.77 10 contracts. Note: We are buying contracts because they deliver dollars not Rupiah. Since we wish to sell Rupiah forward, we agree to buy dollars forward. 4. Again referring to problem 1, suppose that you also owe 2.5 Million PR each year (at the end of the year) for the next three years, and can invest your funds securely at 10% in Afghanistan, how much will you have to hedge, and in what year, to eliminate any exchange rate risk from your obligations/revenues? Also, would you have to buy or sell this amount forward? Finally, how would you hedge the remaining amount using a cross-hedge if 1, 2, and 3 year $/RP futures are available from the Jakarta Exchange (assume the RP and PR are correlated as in problem 3)?
0 Revenue 6 Debt - 2.5 Net 3.5 Savings Interest Balance 3.5 0 3.5 1 - 2.5 - 2.5 1.0 + .35 1.35 2 - 2.5 - 2.5 - 1.15 + .135 - 1.015 3
By netting revenues against your obligations, you will be exposed to a net obligation of 1.015 Million PR three years from now (a net short position). That is the amount you would have to buy forward or cross-hedge in order to be immunized from exchange rate risk. Since you owe PR, and the RP is highly correlated with it, to cross-hedge, you need to buy RP forward. Again, because you are using contracts at the Jakarta exchange which are for US dollars, selling a contract (selling the US Dollar) is the same as buying the RP. So you will sell the amount of 3yr US Dollar/RP futures contracts forward equivalent to 1.015 Million RP, converted at the three year RP/PR forward rate. Think through these arguments--trace them graphically--you will learn a lot.
International Finance Problemset 3 Comprehensive Example: 5. Today is January 05, the current spot rate is 40Baht/$ and 100Y/$. The Explain how you would hedge cash-inflows of 40,000,000 Baht for the next two years using the following instruments, determine the relevant cash-flows, and answer any questions: a. Forwards: Assuming forward rates of 41 and 42 B/$ for one and two years. Do these rates conform to CIPC if the current US treasury rate for one and two years is 3% and 3.15%, and in Thailand, 5% and 5.3%? Are you being charged a premium? b. Futures: Assume that the cash-flows will arrive on the 5th, and Baht futures are available maturing on the 20th of each month. The current January 20 futures price one and two years out is .024361 and .023753 $/Baht respectively. If on January 5th of next year, the spot is 39.80, and the maturing future is priced at .024969, how much have you made or lost on the first hedge? How many dollars will you actually receive? Assume each futures contract controls 100,000 Baht. (Use the forward computed in question a. c. Swap: Assume you can enter into a 2-year swap with a firm at a swap rate of 41.50 B/$, are you better off entering into the swap or forward contracts? Assume that you can borrow in the US over the period at an average rate of 8%. d. Options: If you can purchase Baht puts and calls. Assume that each put contract controls 100,000 baht, and that contracts are available with 1 and 2-year maturities. e. Money Market Hedge: Assume you can borrow in Thailand at a rate of 8.5%; are you better off with a money market hedge or using a forward/swap? f. Cross-hedge: Suppose that none of the above hedging instruments is available to you, but the Baht movement against the dollar is 90% correlated with the Yen. If Yen/$ futures are available for one and two years ahead 102.600, and 105.300, and the Yen/Baht forward for one and two years is 2.499 for both years, approximately what are your expected cash-flows, and is the hedge preferable to using the quoted forwards? Assume each contract controls 1,000,000 Yen. g. Netting: Suppose that you also have Yen debt outstanding requiring interest payments of 100,000,000Yen per year for the next five years. Does that alter your hedging requirements?
International Finance Problemset 3 Answers: a. You sell the Baht forward at the respective forward rates. The cash-flows will be: CF1 = 40,000,000 41 = $975,610 CF2 = 40,000,000 42 = $952,381 Under CIPC, the 1-year and 2-year forwards should be: FB / $,1 = 40 1.05 = 40.7767 1.03 2 FB / $,1 = 40 1.053 = 41.6848 1.0315
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Using those rates, your cash-flows would be: CF1 = 40,000,000 40.7767 = $980,952 CF2 = 40,000,000 41.6848 = $959,581 You are being charged a premium of $5,342 on the first forward agreement, and $7,200 on the second. This may represent a credit differential. b. Sell the Baht forward using 400 Baht futures maturing contracts January 20 of each year. You will close the contracts early (January 5th), this will yield basis risk. If at close the of the first contract, the spot has appreciated to 39.80 (.025126 $/B) over what was anticipated 40.7767 (.024524$/B): Gain on the spot: .025126 - .024524 = .000602$ / B Loss on the future: .024361 - .024969 = .000608$ / B Net loss is: .000006$ / B 40,000,000 B = $240 Remember, with futures, you are targeting the forward rate. You net the forward rate cash-flow, less the loss from the hedge, or: CF1 = $980,952 - $240 = $980,712 Your effective exchange rate is: CF1 = 40,000,000 B $980,712 = 40.78669 B / $ (.024518$/B) c. If you can swap at 41.50, your cash-flows each year will be: 40,000,000 B 41.50 B / $ = $963,855 . To determine whether the forwards or futures are superior from a time-value of money standpoint (obviously they are close), PV the cash-flows at your borrowing rate: CF0 = 0 CF1 = 975,610 $975,610 $952,381 PVForward = + = $1,719,856 CF2 = 952,381 2 1.08 1.08 I/YR = 8 Press 2 Key/NPV 2 $963,855 PVSwap = = $1,718,809 N=2 1.08t t =1
nd
The forwards are superior.
I/YR = 8 PMT = 963,855 FV = 0 Press PV
International Finance Problemset 3 d. You would purchase 400 Baht puts at the forward rate, maturing at or near January 5th of each year. If the Baht depreciated, you would be able to sell your 40,000,000 baht at the strike price. If the Baht appreciated, you would not exercise the puts, but would benefit from any appreciation of the spot. The max losses you would incur would be the cost of the puts, which would also reduce the proceeds from appreciation. e. You borrow the present value of the cash-flows at the Thai, and repay the loan N=2 with the Baht flows. At 8.5%, you would receive: I/YR = 8.5 2 40,000,000 PMT = 40,000,000 PVBaht = = 70,844,571Baht FV = 0 t 1.08.5 t =1 Press PV PV$ = 70,844,571 40 = $1,771,114 This is superior to using the swap or forwards because of the favorable borrowing rate you are receiving (8.5%). Recall the spread between US and Thai treasuries is 2%. Your interest rate differential is .5%; this gives you a relative advantage in borrowing Baht. f. Because of the high-level of correlation with the Yen, you can cross-hedge this currency by selling the Yen forward, or selling Yen futures. Given the current forwards on the Yen, you would sell: 2.499Y / $ 40,000,000 B = 99,960,000Y or 100 Yen contracts for each year. Your anticipated cash-flows would be: CF1 = 99,960,000 102.6 = $974,269 CF2 = 99,960,000 105.3 = $949,288 The forwards yield higher cash-flows, and therefore have higher present values than the cross-hedge. Note also, because of the slight mismatch between the maturity of the future contracts and receipt of cash-flows, the future prices are an approximation of the true forwards. g. Yes. Because of the high correlation with the Yen, the Baht flows could be used to offset Yen exposure for the first two year of interest payments. Again, the hedge will not be perfect, but could be made perfect by selling the Baht forward against the Yen at the current rate of (2.499Y/B). 40,000,000 B 100,000,000Y
International Finance Problemset 3 Translation Risk Create Consolidated Balance sheets and a Translation Exposure Report given the following information: US multinational has $4,000,000 invested in wholly owned Brazilian Subsidiary US firm has $700,000 in receivables from Brazilian firm, Brazilian has 350,000R in receivables from US firm. US firm also have 3,500,000 in Peso Receivables. Brazilian firm has 4,200,000R in debt (including a 5,000,000 Peso external loan, and a $100,000 loan from parent). Current spot rates are 10P/$, 3.5R/$, 2.857R/P. Assets (000's): Cash Receivables Inventories Loans Brazilian Invest. Fixed Assets Total Assets: Liabilities (000's): Payables Debt Common Stock Retained Earnings Total Liabilities: US Firm ($) 500 2,400 3,000 300 4,000 20,000 $30,200 1,500 5,000 20,000 3,700 $30,200 Brazilian (R) 350 3,000 4,000 18,000 R25,350 7,150 4,200 10,000 4,000 R27,350 Combined ($)
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Also, how you would hedge any translation exposure using forward contracts over the next year, and the problems created. If the Peso were highly correlated with the Real (near perfectly correlated) how would that alter t...