CH 11 & 12

CH 11 & 12 - Managing Transaction Exposure 157 0‘...

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Unformatted text preview: Managing Transaction Exposure 157 0‘ lief \ l Summary of Formulas 1) Expected value of the real cost of hedging fimm=zamg 2) Real cost of hedging payables RCHp = NCHP m NCP 3) Real cost of hedging receivables RCH, I NRr ~ NRH, Definitional Problems 1. exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. 2. The term net transaction exposure refers to the consolidation of all expected inflows and outflows for a particular and 3. The goal in multinational financial management is to maximize the value of the overall , not any particular 4. Often, net transaction exposure to each currency is identified and a approach to hedging it taken. 5. MNCs generally do not perceive their foreign exchange management as a _ center. 6. Four techniques to hedge transaction exposure are the futures hedge, the forward hedge, the hedge, and the hedge. 7. Currency _ are very similar to forward contracts, except that they are standardized and are more appropriate for firms that prefer to hedge in smaller amounts. 8. To hedge payables with futures, an MNC would futures; to hedge receivables with futures, an MNC would futures. 9. To use a forward contract hedge, the MNC the currency denominating the payable forward. 10. The measures the additional expenses beyond those incurred without hedging. 11. When the real cost of hedging is , this implies that hedging is more favorable than not hedging. 15 8 Chapter 1 l 12. A hedge involves taking a money market position to cover a future payables or receivables position. 13. If a firm uses a money market hedge to hedge payables, it would borrow and invest in the 14. If a firm uses a money market hedge to hedge receivables, it would borrow and invest in the 15. If interest rate parity (IRP) exists, then the money market hedge will yield the same result as the hedge. 16. A currency option provides the right to buy a specified amount of a particular currency at a specified price within a given period of time. 17. To hedge a receivable with a currency option hedge, an MNC would a option. 18. The price at which a currency put option allows the holder to sell a currency is called the price. 19. Unlike the other hedging techniques in the text, the cash flow associated with the hedge cannot be determined with certainty, because the costs of payables and the revenues generated from receivables are not known ahead of time. 20. To hedge a position with a currency option, one would buy a currency call option. 21. Currency options can be used to hedge , in which an MNC’s exposure is contingent on a specific event happening. 22. When MNCs purchase options to hedge payables, they can finance their purchase by selling options. 23. refers to the hedging of a larger amount in a currency than the actual transaction amount. 24. Techniques for hedging long-term transaction exposure include , and 25. Under a , two firms arrange to exchange currencies at a specified future date for a specified exchange rate. 26. A essentially represents two swaps of currencies, one swap at the inception of the loan contract and another swap at a specified date in the future. 27. If an MNC has a payable in a foreign currency and expects that currency to depreciate, it may delay payment until the currency has depreciated. That is, it may use 28. refers to the acceleration of payments before a foreign currency appreciates. Managing Transaction Exposure 159 29. The hedging of a foreign currency for which no forward contract is available with a highly correlated currency for which a forward contract is available is referred to as 30. If an MNC needs to hedge payables in a relatively stable currency that is not expected to appreciate drastically in the near future, it could use currency 31. If an MNC is unsure whether it will have cash inflows or cash outflows in a particular foreign currency, it can use either currency or currency to hedge. 1. transaction 17. buy; put . 2. time; currency 18. exercise (strike) 3. MNC; subsidiary 19. currency option 4. centralized 20. payable 5. profit 21. contingent exposure 6. money market; currency option 22. call; put 7. futures 23. overhedging 8. buy; sell 24. long-term forward contracts; currency 9. purchases swaps; parallel loans 10. real cost of hedging payables 25. currency swap 1]. negative 26. parallel loan 12. money market 27. lagging 13. dollars; foreign country 28. leading 14. foreign currency; US. 29. cross—hedging 15. forward 30. bullspreads 16. call 31. straddles; strangles True/False Problems " 1. Transaction exposure exists when the future cash transactions of a firm are affected by r ' exchange rate fluctuations. 2. If an MNC assesses net transaction exposure, this refers to the consolidation of all expected inflows for a particular time and currency. 3. Hedging the position of individual subsidiaries is generally necessary, even if the overall performance of the MNC is already insulated by the offsetting positions between subsidiaries. MNC as a whole if local creditors perceive the unhedged exposure of the subsidiary as a g 4. It may be necessary for subsidiaries to hedge even if there is an offsetting position for the credit risk. 5.1/11 previously offsetting effect for the MNC as a whole could be eliminated, or at least “ reduced, if one individual subsidiary decides to hedge its individual exposure. 6. If the forward rate is an unbiased estimator of the future spot rate, then hedging nonselectively is, on average, worthwhile. 160 Chapter 11 7.. An MNC should not hedge any exposure if the forward rate is an unbiased estimator of the future spot rate. ‘ 9. Most MNCs do not perceive their foreign exchange management as a profit center. Rather, ' their main responsibility is to aSSess potential exposure and determine how and if the @ _. MNCs sometimes hedge even if they do not believe hedging to be beneficial. @ exposure should be hedged. 10. Since competitors generally retaliate, an MNC is generally not able to modify its pricing policy to hedge against transaction exposure. 11. In deciding on a hedging technique, MNCs will probably choose the technique that has the highest expected cash flow when hedging payables. 12. A futures contract is very similar to a forward contract, except that forward contracts are ' " more common for larger transactions. 13. To hedge receivables with a futures contract, an MNC would buy currency futures. ._ If a firm is hedging payables with filtures contracts, it may end up paying more for the payable than it would have had it remained unhedged if the foreign currency depreciates. ._ To hedge payables using forward contracts, an MNC would buy the foreign currency forward. 16. The real cost of hedging measures the additional expenses of remaining unhedged versus hedging. 17. When the real cost of hedging is positive, this implies that hedging is more favorable than not hedging. " I 18. If an MNC is extremely risk-averse, it may decide to hedge even though its hedging analysis indicates that remaining unhedged will probably be less costly than hedging. % 19. A money market hedge involves taking a money market position to cover a future payables or receivables position. 20. To hedge a payable position in a foreign currency with a money market hedge, the MNC would borrow the foreign currency, convert it to dollars, and invest that amount in the U-.S. until the payable is due. m 21. If interest rate parity exists, and transaction costs do not exist, the money market hedge will " .5 . “yield the same results as the forward hedge. 22. To hedge a payable position with a currency option hedge, an MNC would write a call option. 23. To hedge a receivable position with a currency option hedge, an MNC would buy a put (option. /'\ Managing Transaction Exposure y if 27. 33. 25 26. hedging decision if it continues to have payables or receivables in that currency. :4 161 24. Whether it is a call or a put, a currency option provides the right, but not the obligation to buy or sell the underlying currency, respectively. . Futures, forward, and money market hedges all lock into a certain price to be received from hedging a receivable For a currency option hedge with a put option, however, the exact amount received is not known until the option is (or is not) exercised. If an MNC, at a given point in time, decides not to hedge, it should periodically reassess the If hedging projections cause a firm to believe that it will definitely be adversely affected by its transaction exposure, a currency option hedge is more appropriate than other methods. . Overhedging refers to the hedging of a larger amount in a currency than the actual transaction amount. . Most MNCs can completely hedge all of their transactions. . An effective way of hedging an uncertain amount of receivables in a foreign currency is to hedge the minimum amount to be received using a money market hedge and to hedge the potential additional amount of receivables using put options. . Although large international banks rarely quote long-term forward rates, they may make exceptions for very creditworthy customers. . Long-term forward contracts, currency swaps, and parallel loans are all tools that can be used Ken/hedge long-term transaction exposure. A currency swap involves an exchange of currencies between two parties, with a promise to reexchange currencies at a specified exchange rate and fiJlCUI'C date. . A parallel loan essentially represents two swaps of currencies. if) . When a parent company tries to convince a subsidiary to hedge its transaction exposure, this is called leading. Lagging refers to the delay of payment by a subsidiary if the currency denominating the payable is expected to depreciate. {,9 Cross-hedging may involve taking a forward position in a currency that is highlypgtrelated with the Currency an MNC needs to hedge. f" , ' L0". The dollar value of firture inflows in foreign currencies will be more stable of the foreign currencies received are not highly positively correlated. . Since forward contracts are easy to use for hedging, any exposure to exchange rate movements should be hedged. . Generally, speaking hedging activities by countries participating in the euro have been reduced since the currency’s inception. 5'; Kg 162 Chapter 1 1 I 41. Generally speaking, a currency strangle could be uSed by an MNC instead of a straddle if the MNC is willing to accept exposure to small exchange rate movements in the foreign currency it is hedging. 42. MNCS should hedge receivables using bearspreads for highly volatile currencies that are expected to depreciate substantially prior to option expiration. Answers to T rue/F else Problems 1. T 22. F 2. F 23. T 3. F 24. T 4. T 25. T 5, T 26. T 6. F 27. F 7. F 28. T 8. T 29. F 9. T 30. T 10. F 31. F 11. F 32. T 12. T 33. F 13. F 34. T 14. T 35. F 15. T 36. T 16. F 37. T 17. F 38. T 18. T 39. F 19. T 40. T 20. F 41. T 21. T 42. F Multiple Choice Problems 1. Which of the following is not normally an example of transaction exposure? Finn X has net receivables in Australian dollars and no other foreign currency transactions. M Firm Y has payables in South Korean won and no other foreign currency transactions. :5; Firm Z has payables in Cyprus pounds from subsidiary A and receivables in the same amount 1 from subsidiary B and no other foreign currency transactions. [9/ Firm XYZ has receivables in Chilean pesos and no other foreign currency transactions. d, 2. Which of the following is not a task associated with managing transaction exposure listed in _ your text? " ' " ' H "5:. Identifying the impact of transaction exposure on the company’s financial statements bf Identifying the degree of transaction exposure Deciding whether to hedge transaction exposure do" Choosing among the various hedging techniques available if it has been decided that transaction exposure should be hedged Managing Transaction Exposure 163 The goal of an MNC is to maximize the Value of each individual subsidiary Value of the MNC has a whole Earnings of each individual subsidiary Earnings of the MNC as a whole pfarmm Cl. 4. Many MNCs choose to hedge only in those situations in which they expect the currency to move in a direction that will make hedging feasible. That is, they may hedge future if they foresee in the underlying currency. Payables; depreciation Receivables; appreciation Payables; appreciation .. ‘ Receivables; depreciation . ' ft: and d I” , . Q 5. Which of the following is nét true‘with respect to MNCs’ management of transaction , exposure? Generally, decisions on whether to hedge, how much to hedge, and how to hedge will vary with the MNC management’s degree of risk aversion. MNCs that hedge most of their exposure do not necessarily expect that hedging will always ,be beneficial. . An MNC may decide not to hedge if its inflow currencies are highly correlated with its ' outflow currencies. d. MNCs generally perceive their foreign exchange management as a profit center. ~\ t WED-99‘?“ The hedge is not a technique to eliminate transaction exposure discussed in your text. - a Index b Futures,_,' ‘ c. Forward. I , (1 Money markets, 6 Currency optionv/ l g 7. Forward contracts can be used to eliminate transaction exposure. For example, to hedge a \ , an MNC could the currency forward. a. Receivable; buy Fb. Receivable; sell pc. Payable; sell d. b and c e. a and c w 8. An MNC can hedge successfully even if the forward rate is an unbiased estimator of the future spot rate if it a. F edges all of its transaction exposure. . Hedges selectively only that exposure by which it would be adversely affected. 0. Hedges selectively only that exposure by which it would be favorably affected. d. None of the above 164 Chapter 1 1 9. Some hedges lock into the rate at which the foreign currency can be bought or sold in the W future. Thus, the cost of hedging may depend on the future spot rate when using the " hedge. a Futures b. "Forward QM?" Currency option d Money market 10. Momoney Corp. frequently uses a forward hedge to hedge its Malaysian ringgit (MYR) i’ receivables. For the next month, Momoney has identified its net exposure to the ringgit as being MYR1,500,000. The 30-day forward rate is $0.23. Furthermore, Momoney’s financial center has indicated that the possible values of the Malaysian ringgit at the end of next month are $0.20 and $0.25, with probabilities of 0.30 and 0.70, respectively. Based on this information, what is the expected real cost of hedging receivables? a. $0 b. -$7,500 c. $7,500 d. None of the above 9/ 11. Hedgealot Corp. frequently uses a forward hedge to hedge its British pound (£) payables. For the next quarter, Hedgealot has identified its net exposure to the pound as being £1,000,000. The 90-day forward rate is $1.50. Furthermore, Hedgealot’s financial center has indicated that the possible values of the British pound at the end of next quarter are $1.57 and $1.59, with probabilities of 0.50 and 0.50, respectively. Based on this information, what is the expected real cost of hedging payables? . a. $80,000 b. -$80,000 c. $1,570,000 d. $1,580,000 I =' 12. Which of the following is not trueiregarding the real cost of hedging? ' a. if the real cost of hedging paygbjesis negatixmeythis implies that hedging is more favorable - 6'." than not hedging. "mm"- b. \ If the real cost of hedging reggmmeg is niggtiye, this implies that hedging is more favorable__ ’than not hedging. " - "W c. If the real cost of hedgingmxables is positjy; this implies that not hedging is more favorable than hedging. fig 5%,. d. If the real cost of hedging receivablesdisflpg'gitdive, this implies that hedging is more favorable , "‘3- than not hedging. ~ -- .f' . .’ f" W’ 13. A money market hedflgehonpaygblggs would involve, among others, borrowing and investing in the The foreign currency; the US. a M b. The foreign currency; foreign country p N _ z c Dollarstforeignflgogntry :bkwé—fig’ v" d Dollars; U.S. ‘ ‘ Managing Transaction Exposure 165 _‘ A money market hedge on receivables would involve, among others, borrowing and investing in the ‘- The foreign currency; the U.S. The foreign currency; foreign country a i. c. Dollars; foreign country d Dollars; U.S. @ The following information refers to questions 15 and 16. 90-day U.S. interest rate {-9.35% 90-day Hong Kong interest rate 5% 90-day forward rate of Hong Kong dollar (HK$) $0.] 15 Spot rate of Hong Kong dollar $0.124 Expected spot rate of Hong Kong dollar in 90 days $0.127 Assume that Santa Monica Corporation in the U.S. will need 700,000 Hong Kong dollars in 90 days to cover a payable. ‘ 5. What is the cost of implementing a forward hedge? $88,900 $80,500 $86,800 None of the above 9.05793" 16. What is the cost of implementing a money market hedge (assume that Santa Monica does not @ have any excess funds available and must therefore borrow)? ' a. $88,058 b. $86,800 0. $85,560 d. $87,630 The following information refers to questions i 7 and 18. ISO—day U.S. interest rate 4% ISO-day Fijian interest rate 5% ISO—day forward rate of Fijian dollar (F8) $0.49 Spot rate of Fijian dollar $0.48 Expected spot rate of Fijian dollar in 90 days $0.47 Assume that Monte Christo Corporation in the U.S. will receive 500,000 Fijian dollars in 180 days. g/ 17. What is value of the receivable if Monte Christo implements a forward hedge? $235,000 $240,000 $245,000 None of the above P-F’P‘?‘ 166 A? b'. C. d. Chapter It What amount will Monte Christo receive in 180 days if it implements a money market hedge and invests any funds received as soon as possible? $237,714 $221,893 $232,762 $242,308 T he following information refers to questions 19 and 20. 53-9575” 155 LOECLZQ 360-day borrowing rate 6% 5% 360-day deposit rate 5% 4% Perkins Corp. will receive 250,000 Jordanian dinar (JOD) in 360 days. The current spot rate of the dinar is $1.48, while the 360-day forward rate is $1.50. How much will Perkins receive in 360 days from implementing a money market hedge (assume any receipts before the date of the receivable are invested)? $377,115 $373,558 $363,019 $370,000 Pablo Corp. will need 150,000 Jordanian dinar (JOD) in 360 days. The current spot rate of the dinar is $1.48, while the 360-day forward rate is $1.46. What is Pablo’s cost from implementing a money market hedge (assume Pablo does not have any excess cash)? $224,133 5 $226,269 $224,114 $223,212 . Lorre Company needs 200,000 Canadian dollars (C58) in 90 days and is trying to determine whether or not to hedge this position. Lorre has developed the following probability distribution for the Canadian dollar: Possible Value of Canadian Dollar in 90 Days Probability $0.54 15%; 0.57 25% 0.58 35% 0.59 25% The 90-day forward rate of the Canadian dollar is $0.575, and the expected spot rate of the Canadian dollar in 90 days is $0.55. If Lorre implements a forward hedge, what is the probability that hedging will be more costly to the firm than not hedging? 40% 60% 5' 15% 85% Managing Transaction Exposure 167 it" i.\22§1"‘¢fAl Corporation will be receiving 300,000 Canadian dollars (C$) in 90 days. Currently, a 90- a it ill Rwrgp .o‘r ‘55"“flay call option with an exercise price of $0.75 and a premium of $0.01 is available. Also, a ‘ 90~day put option with an exercise price of $0.73 and a premium of $0.01 is available. FAI ' plans to purchase options to hedge its receivable position. Assuming that the spot rate in 90 days is $0.71, what is the net amount received from the currency option hedge? $219,000 7 $222,000 $216,000 $213,000 . FAB Corporation will need 200,000 Canadian dollars (C$) in 90 days to cover a payable position. Currently, a 90-day call Option with an exercise price of $0.75 and a premium of $0.01 is available. Also, a 90-day put option with an exercise price of $0.73 and a premium of $0.01 is available. FAI plans to purchase options to hedge its payable position. Assuming that the spot rate in 90 days is $0.71, what is the net amount paid, assuming FAB wishes to minimize its cost? " a. $140,000 b. $148,000 0. $152,000 d. $150,000 T he following information refers to questions 24 and 25. You are the treasurer of Arizona Corporation and must decide how to hedge (if at all) future receivables of 350,000 Australian dollars (AS) 180 days from now. Put options are available for a premium of $0.02 per unit and an exercise price of $0.50 per Australian dollar. The forecasted spot rate of the Australian dollar in 180 days is: Future Spot Rate Probability $0.46 20% $0.48 30% $0.52 50% The ISO-day forward rate of the Australian dollar is $0.50. ‘24. What is the probability that the put option will be exercised (assuming Arizona purchased it?) a. ' 0% b. 80% c. 50% d. None of the above 25. What is the probability that the forward hedge will result in more dollars received than the ' Options hedge? ' a. 0% b. 50% c. 100% d. 20% 6. None of the above 168 Chapter ll . 26. If interest rate parity exists, and transaction costs‘do not exist, the money market hedge will yield the same result as the hedge. W fix R H: m, ‘ V I a. Put option all; .. in}. L.‘ w”! A a n i “ll . vi: l‘: Forward ‘ 0. Cali option if": 7. fix fl: d. None'of the above . Which of the following is thet'least effective way of hedging transaction exposure in the long run? ' Long-term forward contract Currency'swap' Parallel loan Money market hedge When a perfect hedge is not available to eliminate transaction exposure, the firm should consider methods to at least reduce exposure, such as Leading! Lassinsx’" Cross-hedging . Currency diversification . 'All of the above . Which of the following is not an effective way of hedging receivables? Diversify receivables with several negatively correlated currencies Buy a Dummies. Buy a call option c. d. Sell the currency forward The following information refers to questions 30 through 32. Kalonso Imports, Inc. purchases cars from Germany and resells them in the U.S. Kalonso just purchased cars for 62,000,000. Payment for the invoice is due in 60 days, and the current exchange rate for the euro is $1.05. Two call options on euros are available, as shown below. Option 1: Strike price = $1.05 Premium = $.04 per unit Option 2: Strike price = $1.10 Premium = $.03 per unit Kalonso does not believe that the euro will appreciate above $1.10 in the next 60 days. i I 30. Assuming Kalonso can cover the 2 million euros exactly using these options, it could W construct a bull spread by option 1 contracts and option 2 contracts. a. Purchasing; purchasing b. Selling; selling c d Purchasing; selling Selling; purchasing Managing Transaction Exposure 169 , , 3'1. The totai cash outflow necessary to construct the builspread is $ a. 20,000 " b. 60,000 c. 70,000 d. None of the above W If the spot rate of the euro in 60 days is $1.07, what is the net amount Kalonso will pay after H considering all cash flows associated with the options? a. $2,080,000 13. $2,100,000 c. $2,240,000 d. $2,120,000 6. None of the above The following information refers to questions 33 and 34. Petri, Inc. imports furniture from Canada. The Canadian exporter invoices in Canadian dollars (CS). Petri just purchased furniture for 1 million CS and should pay for the furniture in 30 days. It is also possible that Petri will receive 2 million C3 in 30 days from the sale of used furniture in Canada. IfPetri is able to sell the used furniture, it would thus receive a net cash inflow of 1 million C$ in 30 days. The current exchange rate of CS is $.73. The following option information is available: 1) Call option premium on C$ ~"— $.02 2) Put option premium on C$ ‘4 $015 3) Call and put option strike price = $.75 4) One option contract represents C$50,000 33. If Petri uses a long straddle to hedge its position, it would options and 1 options on Canadian dollars. ‘ a Purchase call; write put in Purchase put; write cal] c. Purchase call; purchase put d Sell call; sell put e None of the above “:34. If Petri. is able to sell the used furniture in Canada in 30 days and receives a net cash flow of C$i million, and if the spot rate of C$ in 30 days is $.76, what is the net dollar cash flow Petri would receive? a. $715,000 b. $725,000 c. $755,000 d. $750,000 e. None of the above Answers to Multiple Choice Problems 1. 2. 3 CPS-‘30 9‘9"!“ 6 d a 170 7. 8. 9. 1 OOU‘D- RCH(1) = ( MYR1,500,000 x $0.20) — (MYR1,500,000 x $0.23) = —$45,000 RCH(2) 2 (MYR1,500,000 >< $0.25) — (WRI,500,000 x $0.23) = $30,000 E[RCH] = (.30)(—45,000) + (.7)(30,000) = 7,500 11. b RCH(1) = (£1,000,000 x $1.50) — (£1,000,000 x $1.57) = —$70,000 RCH(2) = (£1,000,000 x $1.50) — (£1,000,000 x $1.59) = «$90,000 E[RCH] : (.50)(—70,000) + (.5)(_—90,000) = —80,000 12. d 13. c 14. a 15. b HK$700,000 x $0.115 = $80,500 16. c 1. Need to invest HK$700,000/1.05 = HK$666,666.67 2. Need to convert $82,666.67 to obtain the 666,666.67 Hong Kong dollars, since the spot rate of the Hong Kong dollar is $0.124 3. At the end 0f90 days, need $82,666.67 >< 1.035 = $85,560 to repay the dollar loan 17. c F$500,000 x $0.49 = $245,000 18. a l. Borrow F$500,000/1.05 = F$476,190.48 Convert F$476,190.48 to $228,571.43 (at $0.48 per Fijian dollar) 3. Invest $228,571.43 at 4% to accumulate $237,714.29 Chapter 1 1 19. d I. Borrow JOD250,000/1.05 2 JOD238,095.24 2. Convert JOD238,095.24 to $352,380.95 (at $1.48 per Jordanian dinar) 3. Invest $352,380.95 at 5% to accumulate $370,000 20. b 1. Need to invest JOD150,000/1.04 = JOD144,230.77 2. Need to convert $213,461.54 to obtain the JOD144,230.76 dinar, since the Spot rate of the dinar is $1.48 3. At the end of 360 days, need $213,461.54 X 1.06 “us $226,269.23 to repay the dollar loan 21. a Since Lorre locks into the $0.575 with a forward contract, the first two cases would have been cheaper had Lorre not hedged (15% + 25% n“— 40%) 22. 0 ($0.73 « $0.01) x 300,000 = $216,000 23. a ($0.71 — $0.01) >< 200,000 = $140,000 Note: the call option is not exercised since the spot rate is less than the exercise price. 24. 0 Arizona will exercise when the exercise price is greater than the future spot rate (20% + 30% = 50%) 25. b Since the per unit amount received under a put option is $0.50 — $0.02 = $0.48 and the forward rate is $0.50, and given that the option is exercised in the first two cases, the forward hedge will result in more dollars received in the first two cases (20% r 30% = 50%) 26. b 27. d 28. e 29. c Managing Transaction Exposure 171 30. c 33. c 31. a 34. b 2,000,000 x ($04 ~ $.03) = $20,000 C$ 1,000,000 >< ($.76 — $.02 — $015) 2 $725,000 Note: Petri will let the call and put options 32. d expire, will sell the C36 in the spot market, 2,000,000 >< $1.05 + $20,000 and net the spot rate less the call and put Note: Kalonso will exercise the option 1 Option Premiums- contracts; the buyer of the option 2 contracts will let them expire. Managing Economic Exposure and Translation Exposu e 175 . . P l 12. Limitations of hedging translation exposure inclu e inadequate inadequate contracts for some currencies, possibly, increased exposure. forecasts, distortions, and, 13. Even if translation exposure does not affect cash flows, it is a concern of many MNCs because it can reduce an MNC’s and thereby cause a decline in its stock price. Answers to Definitional Problems 8. translation 1. economic 2. transaction 9. forward 3. long-term 10. liability 4. economic 11. fixed assets 5. appreciation 12. earnings; forward; accounting; 6. reducing; increasing transaction 7. increasing; reducing l3. consolidated earnings T rue/F alse Problems ‘ 92st" H Economic exposure represents any impact of exchange rate fluctuations on a firm’s future cash flows and thus includes transaction exposure. In general, it is more difficult to effectively hedge economic or translation exposure than to hedge transaction exposure. The management of economic exposure tends to serve as a short—term solution. A foreign subsidiary with more susceptible expenses than revenues to exchange rate movements will be favorably affected by an appreciation of the foreign currency. The way a firm restructures its operations to reduce economic exposure to reduce exchange rate risk depends on the form of exposure. Some revenues or expenses may be more exchange—rate sensitive than others. Therefore, simply matching the quantity of exchange-rate sensitive revenues to the quantity of exchange—rate sensitive expenses may not completely insulate a firm from exchange rate risk. 7. Any restructuring of operations that can reduce the periodic difference between a foreign currency’s inflows and outflows will reduce the firm’SJtranslation exposure. ‘ To reduce economic exposure when a foreign currency has a greater impact on cash inflows, an MNC could reduce its level of foreign sales, increase its foreign supply orders, or restructure debt to increase debt payments in the foreign currency. ‘ 9. One possibility to restructure operations when a foreign currency has a greater impact on cash outflows than on cash inflows is to reduce foreign sales. 10. A foreign subsidiary with high economic exposure could reduce its exposure by financing a portion of its business with loans denominated in the foreign currency. 176 Chapter 12 ll. When an MNC has fixed assets in a foreign country, the dollar cash flows to be received from the ultimate sale of these assets are not subject to exchange rate risk, since the sale will occur in the distant future. 12. A sale of fixed assets in a foreign country can be hedged by creating another asset that matches the expected value of the assets at the point in the future when they may be sold. 13., Even if translation exposure does not affect cash flows, it is a concern of many MNCs. l4. Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial statements. we; 15. Only a small minority of MNCs believe that the hedging of translation exposure is a major concern. @ lot Implementing a forward or money market hedge to hedge translation exposure may increase transaction exposure. ‘@ 17.7 A limitation of hedging translation exposure is that translation losses are not tax deductible, whereas gains on forward contracts used to hedge translation exposure are taxed. E8. The translation gain (or loss) is simply a paper gain (or loss). Conversely, the gain (or loss) ' resulting from a hedge strategy is a real gain (or loss). 0 Answers to T rue/F alse Problems 10. T 11. F 12. F 13. T 14. T 15. F 16. T 17. T 18. T w _ Multiple Choice Problems t. Which of the following statements is ingprreci? (é? a. i/Transaction exposure represents only the exchange rate risk when converting net foreign cash inflows to US. dollars or when purchasing foreign currencies to send payments. b. ,z‘VEconomic exposure represents any impact of exchange rate fluctuations on a finn’s future W cash flows. c. Firms can simply focus on hedging their foreign currency payables and/or receivables to hedge economic exposure. (i. The management of economic exposure tends to serve as a long-term solution rather than just in a short-term solution. a o ewflawewwe eamaammaa a 3%.; ' Managing Economic Exposure and Translation Exposure Thornton Corporationhas extensive liabilities denominated in Cyprus pounds resulting from ,I . imp‘br‘t‘s‘fr‘bifi owever, Thornton’s revenues are denominated solely in US. dollars. i : Which of the following is probably noptgué? t W is" " Hi? Thornton would benefit from a depreciation of the Cyprus pound. gig? I Thornton has at least some transaction exposure. 'fts “‘ Thyfirnton has at least some economic exposure. Thornton has at least some translation exposure. ' All of the above are true. E77 2. 9.9-???” 5-" A U.S.-based MNC has a subsidiary in Barbados that generates substantial net cash inflows denominated in Barbados dollars. Given this information? the would 7_ from of the Barbados dollar. 1. y-p - \ 3(a) ___W aid/Benefit; appreciation b. Benefit; depreciation c. Not benefit; appreciation d. None of the above 4. Campbell Company has a subsidiary located in Jamaica. The subsidiary has generated losses for the last five years and is expected to generate losses for the next ten years. Campbell is reluctant to divest of this subsidiary, however. Given this inforrnations Campbell would from a(n) I of t e Jamaican dollar. a. Benefit; appreciation int L b- Benefit; deprecianom fr. *1“ 6- Not benefitésppreciation l d. Not benefit; depreciation e. b and c 5. Wisconsin Inc. conducts business in Zambia. Years ago, Wisconsin established a subsidiary in Zambia that has consistently generatttd very large profits denominated in Zambian kwacha. Wisconsin wishes to restructure its operations to reduce economic exposure. Which of the following is not a feasible way of alpcomplishing this? ' "i if; ‘3‘“ a. Increase Zambian supply orders " ' Increase Zambian sales c. Restructure debt to increase debt payments ianambia (1. Reduce Zambian sales L/ x, 6. Which of the following is not true regarding the restructuring of operations to reduce economic exposure? ‘ a. Any restructuring that is used to reduce economic exposure may only be reversed or eliminated at a high cost. b. The management of economic exposure serves as a long—term solution. c. Any restructuring of operations that can reduce the periodic difference between a foreign currency’s inflows and outflows can reduce the firm’s economic exposure to that currency’s movements. ' Although economic exposure is a long-term solution, the necessary restructuring of operations to reduce economic exposure is hardly more complicated than hedging any single foreign currency transaction. 178 a :- fl 1‘ Chapter 12 r __ 7. 1\{_I_iller Company has a subsidiary located in Saudi Arabia. In order to reduce economic ex'p'c‘sfiféflVl’iTler restructured its operations Weased supplyorder in Saudi Arabia. Furthermore, it has instructed its Saudi Arabian subsidiarytdborrow more in Saudi Arabian riyal. As a result of this restructuring, the Saudi Arabian subsidiary currently has a zero cash flow. Which of the following statements is correct? I a. The subsidiary should probably be abandoned since it does not generate any cash flows for Miller. The performance evaluation of the Saudi Arabian managers should continue as before the w restructuring, since the subsidiary’s managemenfsfsrresponsible for the restructuring. c. Miller has virtually eliminated its economic exposure regarding the Saudi Arabian subsidiary. . All of the above are true 8. Which of the following firms is not exposed to translation exposure? ' a. Finn X, with a hilly owned subsidiary that periodically remits earnings generated in Great Britain to the U.S.—based parent. b. Firm Y, with a fully owned subsidiary that periodically generates foreign losses in Sweden. The parent covers at least some of these losses. c. Firm Z, with a fiilly owned subsidiary that generates substantial earnings in Germany. The 2bsidiary never remits earnings but reinvests them in Germany. .' . ll of the above firms are exposed to translation exposure. Hopkins Corporation has a subsidiary located in Singapore. Next year, the Singapore subsidfarym’e'étemd to generate income of $332,000,000. Hopkins decidesutomhefldgetitsm_“ translation exposure using a forward contract. The 60-day forward rate for the Singapore dollar is $0.55:7fth?3ingapegdollar by $0.03, Hopkins will have realized of$ . , aifuepreciates; gain; 60,0007”? 7 B i l, “.1? My?! b. . Appreciates; l'6sS‘j‘“6'0,0‘00 "‘ _ n c. Appreciates; gain; 60,000 Grit b” d. DepreCiates; loss; 60,000 J e. 3" ® 10. Which of the following is likely to be the most effective hedge an MNC could use to hedge ‘ the possible sale of fixed assets held in a foreign country in the future? ' - a. The MNC should create an asset that matches the expected value of the assets at the point in the future when they may be sold. b. The MNC should create aliability that matches the expected value of the assets at the point in the fiiture when they may be sold. " c. The MNC should buy futures contracts. :1. The MNC should sell futures contracts. e. The MNC should engage in a money market hedge. 11. is (are) a limitation of hedging translation exposure: Inaccurate earnings forecasts. Inadequate forward contracts for some currencies. Accounting distortions. Increased transaction exposure. All of the above nan-99‘s» at Managing Economic Exposure and Translation Exposure \d 999'.” fly. . those exports in Thai baht. )1 does not incur any expenses denominated in bahLWiioh of the . a: . . l .. L page y 179 . Which of the following is not true regarding hedging translation exposure with the u5e of a forward contract? Assume there is only one foreign subsidiary. If the subsidiary generates income, hedging with a forward contract can backfire if the underlying currency appreciates. .isi'If the foreign subsidiary generates income, depreciation of the underlying currency will result in real losses. ' i The gain or loss resulting from a hedging strategy is a real gain or loss, while the translation gain or loss is a real loss. Since consolidating financial statements requires a weighted average exchange rate, a perfect forward hedge is nearly impossible. All of the above are true . Firms with more revenues than expenses that are sceptible to exchange rate movements are against foreign currencies, while firms whose expenses are more exchange ratewsensitive than their revenues are most concernedthat the__fgreign currency will against their home cu ency. 1 Appreciate; appreciate ‘ 3 5‘3 (g.w,.,__.-A I Deprecrate; depreciate z » i * at ' Appreciate; depreciate * Depreciate; appreciate Inost Concerned-that their home currency will T eh MNC X has a production facility in Thailand and invoices those exports in Thai baht. All of X’s expenses are denominated in baht as well. MNC Y exports to Thailand and denominates ,1 LL following statements istrue“? MNCFX was probably more affected by the Asian crisis than MNC Y was probably more affected by the Asian crisis than MNC X. B0 MNCs were probably equally affected by the Asian crisis. None of the above . b v.- .‘ ("ii-lift? W ' Answers to Multiple Choice Problems wasnswwr c 9. e d S$2,000,000 x $0.03 = $60,000 a e 10. b b 11. e d 12. b c 13. a d 14. b rs" ' ‘ mfié an, :‘t r374 ...
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This note was uploaded on 02/26/2012 for the course FIN 308 taught by Professor Ratner during the Fall '11 term at Rider.

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CH 11 &amp; 12 - Managing Transaction Exposure 157 0‘...

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