˜ Overview
‡ The three major foreign exchange exposures
‡ Foreign exchange transaction exposure
‡ Pros and cons of hedging foreign exchange transaction
exposure
‡ Alternatives of managing significant transaction
exposure
‡ Practices and concerns of foreign exchange risk
management

|

 
   
˜ Types of foreign exchange exposure
‡ @


 ± measures changes in the value of
outstanding financial obligations due to exchange rate changes
‡ 

 ± also called V

 V

V measures
the change in the present value of the firm resulting from any
change in expected future operating cash flows caused by an
unexpected change in exchange rates
‡ @


 ± also called a
 V

V^ is the
changes in owner¶s equity because of the need to ³translate´
financial statements of foreign subsidiaries into a single
reporting currency for consolidated financial statements
‡ @


  as a general rule only
ValV foreign losses are
deductible for purposes of calculating income taxes

|

 
   
Ô   

 
 
 


 


  
  
  
! !  

 
!
 
    

!   

 "  
   

@



#! 
  
"

  
"! 

  ""  ! 
 

@

|

 % &' ( )
˜ Opponents of hedging give the following reasons:
‡ Shareholders are more capable of diversifying risk than the
management of a firm
‡ Currency risk management does not increase the expected cash
flows of a firm
‡ Management often conducts hedging activities that benefit
management at the expense of shareholders
‡ Managers cannot outguess the market
‡ Management¶s motivation to reduce variability is sometimes
driven by accounting reasons
‡ Efficient market theorists believe that investors can see through
the ³accounting veil´ and therefore have already factored the
foreign exchange effect into a firm¶s market valuation

|
$
 % &' ( )
˜ Proponents of hedging give the following reasons:
‡ Reduction in the risk of future cash flows improves the
planning capability of the firm
‡ Reduction of risk in future cash flows reduces the
likelihood that the firm¶s cash flows will fall below a
necessary minimum ± avoiding bankruptcy costs
‡ Management has a comparative advantage over the
individual investor in knowing the actual currency risk
of the firm
‡ Markets are usually in disequilibirum because of
structural and institutional imperfections
‡ Reduction in variability of income reduces a firm¶s
overall tax burden
|
*
 % &' ( )
  

  

 , -.,/  


&
 0
"

 ! !  " !

"
 1



 !

"
 0
 

 !

-"" !
 !
1

|
+
   ! 
 
 
˜ Transaction exposure measures gains or losses that
arise from the settlement of existing financial
obligations^ namely
‡ Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
‡ Borrowing or lending funds when repayment is to be
made in a foreign currency
‡ Being a party to an unperformed forward contract and
‡ Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies

|
2
(
|
 4 5 
˜ Suppose Trident Corporation sells merchandise on open
account to a Belgian buyer for ¼1^

^


payable in 6
days
˜ Further assume that the spot rate is $



¼ and Trident
expects to exchange the euros for ¼1^

^


x $



¼ =
$1^62
^


when payment is received (assuming no change in
exchange rate)
‡ Transaction exposure arises because of the risk that Trident will
receive something other than $1^62
^


expected
‡ If the euro weakens to $
 

¼^ then Trident will receive
$1^
^



‡ If the euro strengthens to $
6

¼^ then Trident will receive
$1^2 ^

|
3
(
|
 4 5 
˜ Trident might have avoided transaction exposure by
invoicing the Belgian buyer in US dollars^ but this
might have caused Trident not being able to book the
sale
˜ Even if the Belgian buyer agrees to pay in dollars^
however^ Trident has not eliminated transaction
exposure^ instead it has transferred it to the Belgian
buyer whose dollar account payable has an unknown
euro value in 6
days

|
6
(
|
 4 5 
:
!| ! 
  

   $
Seller quotes a Buyer places Seller ships Buyer settles
price to buyer firm order with product and AR with cash
seller at bills buyer in amount of
offered price currency
quoted at t1

8
   9

  9

 
Time between quoting Time it takes to fill the Time it takes to get
a price and reaching a order after contract is paid in cash after AR
contractual sale signed is issued

|
7
 9
 : 

˜ A second example of transaction exposure arises
when funds are loaned or borrowed
˜ Example: PepsiCo¶s largest bottler outside the US is
located in Mexico^ Grupo Embotellador de Mexico
(Gemex)
‡ On 12^ Gemex had US dollar denominated debt of
$26 million
‡ The Mexican peso (Ps) was pegged at Ps$
‡ On 1222^ the government allowed the peso to float
due to internal pressures and it sank to Ps6$

|

 9
 : 

˜ Gemex¶s peso obligation now looked like this
‡ Dollar debt mid-December^ 1:
± $26^


^


 Ps$ = Ps1
^

^



‡ Dollar debt in mid-January^ 1:
± $26^


^


 Ps
$ = Ps1^2^


^



‡ Dollar debt increase measured in Ps
± Ps1^2

^



˜ Gemex¶s dollar obligation increased by  due to
transaction exposure

|

 4  ! 
 
 
˜ Vhen a firm buys a forward exchange contract^ it
deliberately creates transaction exposure; this risk is
incurred to hedge an existing exposure
‡ Example: US firm wants to offset transaction exposure
of ¥1

million to pay for an import from Japan in 

days
‡ Firm can purchase ¥1

million in forward market to
cover payment in 
days

|

 &
5  
0
˜ Transaction exposure can be managed by



or 

  
˜ Contractual hedges: forward^ money market^ futures^
and options
˜ Operating and financial hedges use risk-sharing
agreements^ leads and lags in payment terms^ swaps^
and other strategies
˜ A 

  refers to an offsetting operating cash
flow
˜ A 

  refers to either an offsetting debt
obligation or some type of financial derivative such
as a swap
|
$
 
   ;
0
0
˜ Derivatives drive their values from the underlying asset
˜ They might be used for two distinct management objectives:
‡ | 
 ± the financial manager takes a position in the
expectation of profit
‡   ± the financial manager uses the instruments to reduce
the risks of the corporation¶s cash flow
˜ In the wrong hands^ derivatives can cause a corporation to
collapse (Barings^ Allied Irish Bank)^ but used wisely they
allow a financial manager the ability to plan cash flows
˜ The derivatives we will consider are:
‡    
‡   

|
*
 
   
˜ A    
 is an alternative
to a forward contract
‡ It calls for future delivery of a aa
a
 of
currency at a VVa
 V
‡ These contracts are traded on exchanges with the
largest being the Chicago Mercantile Exchange (CME)
˜ Contract Specifications:
‡ |V


a  ± called the notional principal^ trading
in each currency must be done in an even multiple
‡ V

a V a V
aV ± ³American terms´
are used; quotes are in US dollar cost per unit of
foreign currency^ also known as direct quotes
|
+
 
   
˜ Contract Specifications
‡ a
aV ± contracts mature on the rd Vednesday
of January^ March^ April^ June^ July^ September^
October or December
‡ a
a a ± contracts may be traded through the
second business day prior to maturity date
‡ 
llaV
alaVa Va
 ± the purchaser or
trader must deposit an initial margin or collateral
± At the end of each trading day^ the account is a
V

a
V and the balance in the account is either credited
if value of contracts is greater or debited if value of
contracts is less than account balance
|
2
 
   
˜ Contract Specifications
‡ |VlVV ± only  of futures contracts are settled by
physical delivery^ most often buyers and sellers offset
their position prior to delivery date by taking offsetting
positions
± The complete buysell or sellbuy is termed a



‡ 

 ± customers pay a single commission to
their broker to execute a round turn
‡ V
a lVa
 
Vaa
V
a
 ± All
contracts are agreements between the client and the
exchange clearing house Therefore^ there is no
counter-party risk
|
3
 <

   
˜ If an investor wishes to speculate on the movement of
a currency can pursue one of the following strategies
‡ Short position ± selling a futures contract based on
view that currency will fall in value
‡ Long position ± purchase a futures contract based on
view that currency will rise in value

|
6
 <

   
˜ Example (cont): Amy believes that the value of the
peso will fall^ so she sells a March futures contract
˜ By taking a 

 position on the Mexican peso^ Amy
locks-in the right to sell 

^


Mexican pesos at
maturity at a set price above their current spot price
˜ Amy sells one March contract for 

^


pesos at
the settle price: $
1
 Ps

, 
 .|

 /=> ?
  

  .|>  /

|
7
 <

   
˜ To calculate the value of Amy¶s position we use the following
formula
, 
 .|

 /=> ?
  

  .|>  /

˜ Using the settle price from the table and assuming a spot rate
of $


Ps at maturity^ Amy¶s profit is
, => ( *77-777 .@7176$*7A( > @7176*3A( /=@2-*$7
˜ If Amy believed that the Mexican peso would rise in value^
she would take a long position on the peso
, 
 .: 

 /=?
  

  .|>  /

˜ Using the settle price from the table and assuming a spot rate
of $
11

Ps at maturity^ Amy¶s profit is
, =( *77-777 .@71*77A( > @7176*3A( /=@-27 |


    ,  
 
 
    
 
ÿ

 V ÿustomized tandardized
VlV
V ÿustomized tandardized

  anks^ brokers^ Nÿs ublic anks^ brokers^ Nÿ Quali ied
speculation not encouraged public speculators
|V
V
 ÿompensating bank balances or mall security deposit required
credit lines needed
ÿlV
  Handled by individual banks and Handled by exchange clearinghouse

V

 brokers aily settlements

Vl V Vorld ide ÿentral exchange
V l
 el -regulating ÿommodity utures Trading
ÿommission (ÿ Tÿ) and National
utures ssociation
 
 ostly settled by actual delivery ostly settled by o setting
transactions

 
 ank¶s bidask spread Negotiated brokerage ees
ÿ


|

 
   4

˜ A   is a contract giving the
purchaser of the option the right to buy or sell a given
amount of currency at a fixed price per unit for a
specified time period
‡ The most important part of clause is the ³right^ but not
the obligation´ to take an action
‡ Two basic types of options^ 
 and 
± 
 ± buyer has right to purchase currency
±  buyer has right to sell currency
‡ The buyer of the option is the 
lV
and the seller of
the option is termed the
V

|

 
   4

˜ Every option has three different price elements
‡ The  ! or
   is the exchange rate at
which the foreign currency can be purchased or sold
‡ The  ^ the cost^ price or value of the option
itself paid at time option is purchased
‡ Spot exchange rate in the market
˜ There are two types of option maturities
‡  
 may be exercised at any time during
the life of the option
‡  
 may not be exercised until the
specified maturity date

|
$
 
   4

˜ Options may also be classified as per their payouts
‡ " "  @Ôoptions have an exercise price
equal to the spot rate of the underlying currency
‡ #" " #@Ô options may be profitable^
excluding premium costs^ if exercised immediately
‡ "" " @Ô options would not be
profitable^ excluding the premium costs^ if exercised

|
*

   4
 

˜ $ " " @Ô
!  ± OTC options are most
frequently written by banks for US dollars against British
pounds^ Swiss francs^ Japanese yen^ Canadian dollars and the
euro
‡ Main advantage is that they are tailored to purchaser
‡ Counterparty risk exists
‡ Mostly used by individuals and banks
˜  
% 

  ± similar to the futures market^
currency options are traded on an organized exchange floor
‡ The Chicago Mercantile and the Philadelphia Stock Exchange
serve options markets
‡ Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)

|
+
 
   
  
˜ CFO of Trident^ has just concluded a sale to Regency^ a British
firm^ for £1^


^



˜ The sale is made in March for settlement due in June ( months)
‡ Assumptions
± Spot rate is $16
£
± -month forward rate is $1
£ (a 22 discount)
± Trident¶s cost of capital is 12

± UK  month borrowing rate is 1

pa
± UK  month investing rate is 
pa
± US  month borrowing rate is 
pa
± US  month investing rate is 6
pa
± June put option in OTC market for £1^


^


; strike price $1£;
priced at $

26£
± Trident¶s foreign exchange advisory service forecasts future spot rate in 
months to be $16

£
˜ The 0  V
aV (lowest acceptable amount) is based on an
exchange rate of $1


£
|
2
 
   
  
˜ Trident faces four possibilities:
‡ Remain unhedged
‡ edge in the forward market
‡ edge in the money market
‡ edge in the futures market
‡ edge in the options market

|
3
 
   
  
˜ Unhedged position
‡ If the future spot rate is $16£^ then Trident will
receive £1^


^


x $16£ = $1^6
^


in 
months
‡ owever^ if the future spot rate is $16£^ Trident will
receive only $1^6
^


well below the budget rate

|
6
 
   
  
˜ Forward Market hedge
‡ A forward hedge involves a forward contract
‡ The forward contract is entered at the time the AR is created^ in this
case in March
‡ Vhen this sale is booked^ it is recorded at the spot rate
‡ In this case the AR is recorded at a spot rate of $16
£^ thus
$1^6^


is recorded as a sale for Trident
‡ If the firm wants to cover this exposure with a forward contract^ then
the firm will sell £1^


^


forward today at the $1
£
‡ In  months^ Trident will received £1^


^


and exchange those
pounds at $1
£ receiving $1^^



‡ This sum is $6^


less than the uncertain $1^6
^


expected from
the unhedged position
‡ This would be recorded in Trident¶s books as a foreign exchange loss
of $1
^


($1^6^


as booked^ $1^^


as settled)
|
7
 
   
  
˜ Money Market hedge
‡ To hedge in the money market^ Trident will borrow
pounds in London^ convert the pounds to dollars and
repay the pound loan with the proceeds from the sale
± To calculate how much to borrow^ Trident needs to discount
the PV of the £1^


^


to today
± £1^


^


1
2 = £^61

± Trident should borrow £^61
today and in  months
repay this amount plus £2^
in interest (£1^


^


)
from the proceeds of the sale
± Trident would exchange the £^61
at the spot rate of
$16
£ and receive $1^2
^6 at once (today)
± This hedge creates a pound denominated liability that is
offset with a pound denominated asset thus creating a
0ala VVVV V
|

 
   
  
˜ In order to compare the forward hedge with the money market
hedge^ we must analyze the use of the loan proceeds
‡ Remember that the loan proceeds may be used today^ but the funds
for the forward contract may not
‡ Because the funds are relatively certain^ comparison is possible in
order to make a decision (the comparison is made on future values)
‡ Three logical choices exist for an assumed investment rate for the
next  months
± First^ if Trident is cash rich the loan proceeds might be invested at the
US rate of 6
pa
± Second^ the loan proceeds can be substituted for an equal dollar loan
that Trident would have otherwise taken for working capital needs at
a rate of 
pa
± Third^ the loan proceeds can be invested in the firm itself in which
case the cost of capital is 12
pa

|

 
   
  
˜ Because the proceeds in  months from the forward hedge will
be $1^^


^ the money market hedge is superior to the
forward hedge if the proceeds are used to replace a dollar loan
( ) or conduct general business operations (12 )
˜ The forward hedge would be preferable if the loan proceeds
are invested at (6 )
˜ Ve will assume the cost of capital as the reinvestment rate
÷V VV
a !VV ÷aV " 
Val V#


$1^2
^6 Treasury bill 6 pa or 1 quarter $1^6^1

$1^2
^6 Debt cost pa or 2
quarter $1^^6

$1^2
^6 Cost of capital 12 pa or 
quarter $1^2^6


|

 
   
  
˜ A breakeven investment rate can be calculated
between forward and money market hedge
)
a  

VV(  )
+
aV(=)

a
  

VV(
$
% %*  )
+
(=$
%&'   

=    


˜ To convert this  month rate to an annual rate^

#* 
   
 
  =% *+,
 
˜ In other words^ if Trident can invest the loan proceeds at a rate
equal to or greater than 6 pa then the money market
hedge will be superior to the forward hedge
|
$
 
   
  
, 
<|  !

  B-777-7775A < 0
 
0 

13$  

67

@12*$7AB
13

137
  


  @-22-+7*
123

12+

12$
 

  @-2*$-777
12

127

1+3
1+3 127 12 12$ 12+ 123 137 13 13$ 13+

 
  .<|@AB/ |
*

 
   
  
˜ Futures market hedge
‡ Trident could also cover the £1^


^


exposure by selling futures
contracts now at say $1
£ - most futures contracts are not
delivered therefore instead of spot rate you would have purchase
price of the futures contract below
‡ If spot rate is $16

£ then the result of futures position is:
, 
 .|

 /=> ?
  

  .|>  /
, 
 .|

 /=> B-777-777 .@12+77AB > @12*$7AB/
, 
 .|

 /=> @+-777
‡ The loss on futures would reduce the value of receivable
, !
0" =B-777-777 @12+77AB =@-2+7-777
‡ The net value of receivable is:
‡ $1^6
^


± $6^


= $1^^



‡ Implied exchange rate of conversion is
‡ $1^^


 £1^


^


= $1
£ (Rate at which we sold futures
contracts |
+
 
   
  
˜ Option market hedge
‡ Trident could also cover the £1^


^


exposure by
purchasing a put option This provides the upside
potential for appreciation of the pound while limiting
the downside risk
± Given the quote earlier^ a -month put option can be
purchased with a strike price of $1£ and a premium
of $

26£
± The cost of this option would be
)|V
 

()
V (=

 


.
      $   *&-.=$*'* 

|
2
 
   
  
˜ Because we are using future value to compare the various hedging
alternatives^ we need future value of the option cost in  months
˜ Using a cost of capital of 12 pa or 
per quarter^ the
premium cost of the option as of June would be
‡ $26^6
 1
 = $2^2 or $2^2  £1^


^


= $

2£
˜ Since the upside potential is unlimited^ Trident would not exercise
its option at any rate above $1£ and would convert pounds to
dollars at the spot market
˜ If the spot rate is $16£^ Trident would exchange pounds on the
spot market to receive £1^


^


 $16£ = $1^6
^


less the
premium of the option ($2^2) netting $1^2^6
˜ If the pound depreciates below $1£^ Trident would exercise the
put option and exchange £1^


^


at $1£ receiving
$1^
^


less the premium of the option netting $1^22^6

|
3
 
   
  
˜ As with the forward and money market hedges^ a
breakeven price on the option can be calculated
‡ The upper bound of the range is determined by
comparison of the forward rate
± The pound must appreciate above $1£ forward rate
plus the cost of the option^ $

2£^ to $1 1£
‡ The lower bound of the range is determined by
comparison to the strike price
± If the pound depreciates below $1£^ the net proceeds
would be $1£ less the cost of $

2£ or $122£
± ote that the following graph shows the net proceeds of
the option contract under varying exchange rates et
proceeds are not same of a put option payoff diagram
because we have exposure to the underlying asset (£)
|
6
 
   
  

¦ /
|
V¦
 V 0 /
$
%&-.

Option cost (future cost) $2^2

Proceeds if exercised $1^
^

Minimum net proceeds $1^22^6

Maximum net proceeds unlimited

Breakeven spot rate (upside) $1 1£

Breakeven spot rate (downside) $1221£

|
$7
 A C E
1 Exposure £1^000^000
2 ut Exercise 1
 ut re iu 002 (F )
 pot ate nhedged For ard ut ption
 168 $1^680^000 $1^2^60 $1^^000 $1^22^6
6 169 $1^690^000 $1^2^60 $1^^000 $1^22^6
 10 $1^00^000 $1^2^60 $1^^000 $1^22^6
11 $1^10^000 $1^2^60 $1^^000 $1^22^6
 12 $1^20^000 $1^2^60 $1^^000 $1^22^6
10 1 $1^0^000 $1^2^60 $1^^000 $1^22^6
11 1 $1^0^000 $1^2^60 $1^^000 $1^22^6
12 1 $1^0^000 $1^2^60 $1^^000 $1^22^6
1 16 $1^60^000 $1^2^60 $1^^000 $1^2^6
1 1 $1^0^000 $1^2^60 $1^^000 $1^2^6
1 18 $1^80^000 $1^2^60 $1^^000 $1^2^6
16 19 $1^90^000 $1^2^60 $1^^000 $1^62^6
1 180 $1^800^000 $1^2^60 $1^^000 $1^2^6
18 181 $1^810^000 $1^2^60 $1^^000 $1^82^6
19 182 $1^820^000 $1^2^60 $1^^000 $1^92^6
20 18 $1^80^000 $1^2^60 $1^^000 $1^802^6
21 18 $1^80^000 $1^2^60 $1^^000 $1^812^6
22 18 $1^80^000 $1^2^60 $1^^000 $1^822^6
2 186 $1^860^000 $1^2^60 $1^^000 $1^82^6
2 18 $1^80^000 $1^2^60 $1^^000 $1^82^6
2 188 $1^880^000 $1^2^60 $1^^000 $1^82^6
26 189 $1^890^000 $1^2^60 $1^^000 $1^862^6
2 190 $1^900^000 $1^2^60 $1^^000 $1^82^6

Cell E Entry is =IF(A

$C$2^($C$2-$C$)*$C$1^(A-$C$)*$C$1) |
$
 
 


    

-  -

- -

- -

- -

- $ -

-  -
   

- -

- -

- -

- $ -

-  -

- -

- -

- -
1 1 1 1 1  1 1 $ 1 1 1 1 1 1 1 1  1 1 $ 1 1 1 1 1 1
  

|
$
 | 
 4
˜ Trident^ like all firms^ must decide on a strategy to
undertake before the exchange rate changes but how a
choice can be made among the strategies?
˜ Two criteria can be utilized:
‡ ÷!
 - of the firm^as expressed in its stated
policies and
‡ &  > managers¶ view on the expected direction
and distance of the exchange rate
˜ Trident now needs to compare the alternatives and
their outcomes in order to choose a strategy
˜ There were four alternatives available to manage this
account receivable

|
$
 | 
 4
mV  |
aV  / 
V-¦a


Remain uncovered Unknown

Forward Contract hedge @ $1£ $1^^

Money market hedge @ pa $1^^6

Money market hedge @ 12 pa $1^2^6


Put option hedge @ strike $1£

Minimum if exercised $1^22^6
Maximum if not exercised Unlimited

|
$$
  
 5 ( " 
˜ The choices are the same for managing a payable
‡ Assume that the £1^


^


was an account payable in

days
˜ ÷Va V V± Trident could wait the 
days
and at that time exchange dollars for pounds to pay
the obligation
‡ If the spot rate is $16

£ then Trident would pay
$1^6
^


but this amount is not certain

|
$*
  
 5 ( " 
˜ Va

a
a
VV V ± Trident could

aV a forward contract locking in the $1£
rate ensuring that their obligation will not be more
than $1^^



˜ Va
Va
VV V ± this hedge is distinctly
different for a payable than a receivable
‡ ere Trident would exchange US dollars at the spot
rate and invest them for 
days in pounds
‡ The pound obligation for Trident is now offset by a
pound asset for Trident with matching maturity

|
$+
  
 5 ( " 
˜  a
Va
VV V ±
‡ To ensure that exactly £1^


^


will be received in 
months^ discount the principal by pa
.
      
 .+ #
*
 

1    +  
#* 

‡ This £
^216 would require $1^2^11 at the

current spot rate
.+ #
*  $
%*' -. =$
%'

%%

|
$2
  
 5 ( " 
˜  a
Va
VV V±
‡ Finally^ carry the cost forward 
days using the cost
of capital in order to compare the payout from the
money market hedge

  

$1^2^11 x 1 
12 x  š $1^ 1^212

6


‡ This is higher than the forward hedge of $1^^

thus unattractive

|
$3
  
 5 ( " 
˜ Futures market hedge
‡ Trident could also cover the £1^


^


exposure by buying futures
contracts now at say $1
£
‡ If spot rate is $16

£ then the result of futures position is:
, 
 .: 

 /=?
  

  .|>  /
, 
 .: 

 /=B-777-777 .@12+77AB> @12*$7AB/
, 
 .: 

 /=@+-777
‡ The gain on futures would reduce the value of payable
, ! " =>B-777-777 @12+77AB =>@-2+7-777
‡ The net value of payable is:
‡ ±$1^6
^


+ $6^


= ±$1^^



‡ Implied exchange rate of conversion is
‡ $1^^


 £1^


^


= $1
£ (Rate at which we bought
futures contracts

|
$6
  
 5 ( " 
˜  a

V V ± instead of purchasing a put
as with a receivable^ you want to purchase a call
option on the payable
‡ The total cost of an ATM call option with strike price
of $1£ and a premium of $

26£:
)|V
 

()
V (=

 


.
      $   *&-.=$*'* 
‡ Carried forward 
days the premium amount is
$26^6
 1
 = $2^2 or $2^2  £1^


^


=
$

2£

|
*7
  
 5 ( " 
˜  a all

V V ±
‡ If the spot rate is less than $1£ then the option
would be allowed to expire and the £1^


^


would
be purchased on the spot market
‡ If the spot rate rises above $1£ then the option
would be exercised and Trident would exchange the
£1^


^


at $1£ less the option premium for the
payable
Exercise call option (£1^


^


 $1£) $1^
^



Call option premium (carried forward 
days) $2^2
Total maximum expense of call option hedge $1^^2

|
*
 A B C D E
1 Exposure £1^000^000
2 Call Exercise 1
 Call Premium 002 (FV)
 Spot Rate Unhedged Forward Call Option
 16 $1^6 0^000 $1^ 1^29 $1^^000 $1^0^2
6 169 $1^690^000 $1^ 1^29 $1^^000 $1^1^2
 10 $1^00^000 $1^ 1^29 $1^^000 $1^2^2
11 $1^10^000 $1^ 1^29 $1^^000 $1^^2
9 12 $1^20^000 $1^ 1^29 $1^^000 $1^^2
10 1 $1^0^000 $1^ 1^29 $1^^000 $1^^2
11 1 $1^0^000 $1^ 1^29 $1^^000 $1^6^2
12 1 $1^0^000 $1^ 1^29 $1^^000 $1^^2
1 16 $1^60^000 $1^ 1^29 $1^^000 $1^^2
1 1 $1^0^000 $1^ 1^29 $1^^000 $1^^2
1 1 $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
16 19 $1^90^000 $1^ 1^29 $1^^000 $1^^2
1 1 0 $1^ 00^000 $1^ 1^29 $1^^000 $1^^2
1 1 1 $1^ 10^000 $1^ 1^29 $1^^000 $1^^2
19 1 2 $1^ 20^000 $1^ 1^29 $1^^000 $1^^2
20 1  $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
21 1  $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
22 1  $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
2 1 6 $1^ 60^000 $1^ 1^29 $1^^000 $1^^2
2 1  $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
2 1 $1^ 0^000 $1^ 1^29 $1^^000 $1^^2
26 1 9 $1^ 90^000 $1^ 1^29 $1^^000 $1^^2
2 190 $1^900^000 $1^ 1^29 $1^^000 $1^^2
Cell E Entry is =IF(A$C$2^($C$2+$C$)*$C$1^(A+$C$)*$C$1) |
*
 
5 


<      

- -

- -

- -

- -

- -

- -
?   

- -

- -

- -

- -

- -

- -

- -

- -
1 1 1 1 1 1  1 1 * 1 1 1 1 1 1 1 1  1 1 * 1 1 1 1 1
  

|
*
 

  
(

˜ %
C D
‡ The treasury function of most firms is usual considered a cost center;
it is not expected to add to the bottom line
‡ owever^ in practice some firms¶ treasuries have become aggressive
in currency management and act as profit centers
˜ %
  D
‡ Transaction exposures exist before they are actually booked yet
some firms do not hedge this backlog exposure
‡ owever^ some firms are selectively hedging these backlog
exposures and anticipated exposures
˜ %
  & D
‡ Transaction exposure management programs are generally divided
along an ³option-line;´ those which use options and those that do not
‡ Also the amount of risk covered may vary Tare are 




al
V  policies that state which proportion and type of exposure is
to be hedged by the treasury
|
*$
  
˜ Dragon Inc^ of Moorhead purchased a Korean company that produces plastic
nuts and bolts for auto manufacturers The purchase price was Von^


million Von1^


million has already been paid and the remaining Von6^


million is due in six months The current spot rate is Von1^2

$^ and the 6-
month forward rate is Von1^26
$
˜ Additional data:
‡ Six-month Korean interest rate: 16

pa
‡ Six-month US interest rate: 

pa
‡ Six-month call option on Korean Von at 1^26
with a premium of
Von$
‡ Six-month put option on Korean Von at 12

with a premium of
Von16$
‡ Dragon can invest at the rates given above or borrow at 2 pa above those
rates Dragon¶s cost of capital is 2 
˜ Compare hedging alternatives and make a recommendation

|
**