Chapter 9 Sample Problem

International Financial Management

171114 Chapter 9 Sample Problem 1

Problem 1
• Suppose that you hold a piece of land in the city of London that
you may want to sell in one year. As a U.S. resident, you are
concerned with the dollar value of the land. Assume that if the
British economy booms in the future, the land will be worth
£2,000, and one British pound will be worth $1.40. If the British
economy slows down, on the other hand, the land will be worth
less, say, £1,500, but the pound will be stronger, say, $1.50/£.
You feel that the British economy will experience a boom with a
60 percent probability and a slowdown with a 40 percent
probability.

171114 Chapter 9 Sample Problem 2

Problem 1 (cont.)
a. Estimate your exposure (b) to the exchange risk.

b. Compute the variance of the dollar value of your property that is

attributable to exchange rate uncertainty.

c. Discuss how you can hedge your exchange risk exposure and
also examine the consequences of hedging.

171114 Chapter 9 Sample Problem 3

Problem 1.a Answer
a. Estimate your exposure (b) to the exchange risk.

Cov 𝑃, 𝑆
𝑏=
Var 𝑆

hence, need Var[S] and Cov[P,S]; find E[S] and E[P] first
P* S P=P*×S
State Probability Prob.×S Prob.×P
(£ price) (spot rate) ($ price)

Booms 0.6 2000 1.4 2800 0.84 1680

Slows down 0.4 1500 1.5 2250 0.60 900

E[S]= E[P]=
1.44 2580

171114 Chapter 9 Sample Problem 4

Problem 1.a Answer (cont.)
a. Estimate your exposure (b) to the exchange risk.

Cov 𝑃, 𝑆
𝑏=
Var 𝑆

Find Var[S] second

S Prob.×
State Probability Deviation Deviation2
(spot rate) Deviation2

Booms 0.6 1.4 −0.04 0.0016 0.00096

Slows down 0.4 1.5 0.06 0.0036 0.00144

E[S]= Var[S]=
1.44 0.0024

171114 Chapter 9 Sample Problem 5

Problem 1.a Answer (cont.)
a. Estimate your exposure (b) to the exchange risk.

Cov 𝑃, 𝑆
𝑏=
Var 𝑆

Find Cov[P,S] third

P S Deviation P×
State Probability Deviation P Deviation S
Deviation S
×Prob.
($ price) (spot rate)

Booms 0.6 2800 220 1.4 −0.04 −8.8 −5.28

Slows
0.4 2250 −330 1.5 0.06 −19.8 −7.92
down
E[P]= E[S]= Cov[P,S]=
2580 1.44 −13.2

171114 Chapter 9 Sample Problem 6

Problem 1.a Answer (cont.)
a. Estimate your exposure (b) to the exchange risk.

Cov 𝑃, 𝑆
𝑏=
Var 𝑆

Var[S]=0.0024 from the second step

Cov[P,S]=−13.2 from the third step

Cov 𝑃,𝑆 −13.2

b= = =−£5500
Var 𝑆 0.0024

P decreases by $5500 as S increases by $1/£

171114 Chapter 9 Sample Problem 7

Problem 1.b Answer
b. Compute the variance of the dollar value of your property that is
attributable to exchange rate uncertainty.

Regression equation: P = a+bS+e

Take the variance: Var[P] = Var[a+bS+e]

(a is not random variable→) = Var[bS+e]

(S and e are uncorrelated→) = Var[bS]+Var[e]

(b is not random variable→) = b2Var[S]+Var[e]

171114 Chapter 9 Sample Problem 8

Problem 1.b Answer (cont.)
b. Compute the variance of the dollar value of your property that is
attributable to exchange rate uncertainty.

Var 𝑃 = 𝑏 2 Var 𝑆 + Var 𝑒

Total variance attributable remainder
to 𝑆 proportion

b=5500 from 1.a

Var[S]=0.0024 from the second step

b2Var[S]=55002×0.0024=72,600

171114 Chapter 9 Sample Problem 9

Problem 1 (cont.)
c. Discuss how you can hedge your exchange risk exposure and
also examine the consequences of hedging.

The exchange rate exposure b=−£5,500 is negative.

One dollar increase in the spot rate would result in $5,500 loss
of the property value

In order to hedge this, buy 5,500 GBP forward

This position will give you $5,500 for each one dollar increase
in the spot rate

Completely cancel the negative exchange rate exposure

171114 Chapter 9 Sample Problem 10

Problem 2
• A U.S. firm holds an asset in France and faces the following
scenario:

In the above table, P* is the euro price of the asset held by the
U.S. firm and P is the dollar price of the asset.

171114 Chapter 9 Sample Problem 11

Problem 2 (cont.)
a. Compute the exchange exposure faced by the U.S. firm.

b. What is the variance of the dollar price of this asset if the U.S.
firm remains unhedged against this exposure?

c. If the U.S. firm hedges against this exposure using a forward

contract, what is the variance of the dollar value of the hedged
position?

171114 Chapter 9 Sample Problem 12

Problem 2.a Answer
a. Compute the exchange exposure faced by the U.S. firm.

E[S] = 0.25(1.2)+0.25(1.1)+0.25(1)+0.25(0.9)
= 1.05

Var[S] = 0.25(1.2−1.05)2+0.25(0.05)2
+0.25(−0.05)2+0.25(−0.15)2
= 0.0125

E[P] = 0.25(1800)+0.25(1540)
+0.25(1300)+0.25(1080)
= 1430

Cov[P,S] = 0.25(1.2−1.05)(1800−1430)+0.25(0.05)(110)
+0.25(−0.05)(−130)+0.25(−0.15)(−350)
= 13.875+1.375+1.625+13.125
= 30
171114 Chapter 9 Sample Problem 13
Problem 2.a Answer (cont.)
a. Compute the exchange exposure faced by the U.S. firm.

Therefore,

b=Cov[P,S]/Var[S]=30/0.0125=€2400

The exchange rate exposure of this asset is positive

The dollar price of this asset increases by $2,400 as the exchange

rate increases by $1/€

(In order to hedge this positive exposure, must sell 2,400 Euro
forwards)

171114 Chapter 9 Sample Problem 14

Problem 2.b and 2.c Answer
b. What is the variance of the dollar price of this asset if the U.S. firm
remains unhedged against this exposure?

b2Var[S] = 24002×0.0125
= 72000

This variance can be cancelled by selling 2,400 Euro forwards

c. If the U.S. firm hedges against this exposure using a forward contract,
what is the variance of the dollar value of the hedged position?

Var[P] = 0.25(1800−1430)2+0.25(110)2
+0.25(−130)2+0.25(350)2
= 72100

Hence the remainder unhedged variance is 100 (=72,100−72,000)

171114 Chapter 9 Sample Problem 15

 Q&A Session
Thanks for Listening

171114 Chapter 9 Sample Problem 16