WEEK 6

Ex 28-33

Chapter 13: Exercises 2, 3, 4, 6

Ex28 Exercise 2

Dell Inc. purchased DRAM integrated circuits from Elpida Memory, Inc., a Japanese manufacturer, and was
billed 250 million payable in three months. Currently, the spot exchange rate is 105/$ and the three-month
forward rate is 100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7
percent per annum in Japan. The management of Dell decided to use the money market hedge to deal with this
yen account payable.

(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

(b) Conduct the cash flow analysis of the money market hedge.

Solution

Money Market hedge: match your receivables in foreign currency with an equivalent liability in the same
currency or your liabilities with foreign investments
3-months Japanese rate: 7%/4 = 1.75%
3-months US rate: 8%/4=2%
250m/1.0175 = 245,700,245.70

Cost you now USD: = 245,700,245.70/105 = $2,340,002.34

CF0:

$2,340,002.34 to buy 245,700,245.70

Invest 245,700,245.70

CF1:

Receive 250,000,000 from investment, pay 250,000,000 for the acquisition

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Ex 29 Exercise 3

You plan to visit Geneva, Switzerland in three months to attend an international business conference. You
expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today,
the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month
call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your
expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent
per annum in the United States and 4 percent per annum in Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.

(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward
contract.

(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?

(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both
the options and forward market hedges.

Solution

US three-month rate: 6%/4 =1.5%

Swiss three-month rate: 4%/4 = 1%
(a) Using options

Premium = .05 $/SFR X 5000 SFR = $250. FV= $250 X 1.015 = $253.75

Expected future spot price < Exercise price Option expected to expire out of the money

Buy SFR at 0.63 0.63 X 5,000 = $3,150

Total cost = $3,403.75 at future value

(b) Using forwards

$3,150 = 0.63 X 5,000

(c) St s.t. you are indifferent between options and forwards

With forwards you lock in the rate, with options you can decide; if the spot rate is such that:

$3,150 = 5,000 X St + 253.75, you are indifferent between forward and options St = $0.57925/SF

(d)

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With the option, you never pay more than 0.64 0.64 SF5,000 for $3,200. The total cost of buying SF5,000 will
be $3,453.75 = $3,200 + $253.75. This is the maximum you will pay for SF5,000.

With forwards, you will surely pay $3,150

Ex 30 Exercise 4

Boeing just signed a contract to sell a Boeing 747 aircraft to Air France. Air France will be billed 300 million
which is payable in one year. The current spot exchange rate is $1.05/ and the one-year forward rate is
$1.10/. The annual interest rate is 6.0% in the U.S. and 5.0% in France. Boeing is concerned with the volatile
exchange rate between the dollar and the euro and would like to hedge exchange exposure.

(a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow euros
from Credit Lyonnaise against the euro receivable. Which alternative would you recommend? Why?

(b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two
hedging methods?

Solution

Forward: 300,000,000 X 1.10 = $330,000,000.

MMH:

- Borrow : 300,000,000/1.05 =285,714,286

- Buy $: 285,714,286 X 1.05 = $300,000,000
- Invest $: $300,000,000 X 1.06 = $318,000,000

The equilibrium forward rate is F = S0 * (1+i$)/(1+i) = 1.05*1.06/1.05 = 1.06 $/

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Ex 31 Exercise 6

Carnival Corporation & plc of the U.K. purchased a ship from Mitsubishi Heavy Industry. Carnival owes
Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per pound and the one-
year forward rate is 110 yen per pound. The annual interest rate is 5% in Japan and 8% in the U.K. Carnival can
also buy a one-year call option on yen at the strike price of .0081 per yen for a premium of .014 pence per
yen.

(a) Compute the future pound costs of meeting this obligation using the money market hedge and the forward
hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the
expected future pound cost of meeting this obligation when the option hedge is used.

(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?

Solution

Forward: 500,000,000/110 = 4,545,455

MMH: [(500 mln) /(1.05)](124)] x (1.08)= 4,147,465.

Option:

Premium = (0.014/100) X 500,000,000 = 70,000 FV = 70,000 X 1.08 = 75,600.

E[St] = 1/110 = 0.0091 > .0081 Use the option .0081 X 500,000,000 = 4,050,000

E[Total cost] = 4,125,600

(c) MMH cost does not depend on future spot rate. Expected cost with the option cannot be higher than the
value computed above. Hedging with options always dominate MMH.

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Ex 32 Minicase 1, Chapter 18

The Trendy Designs Company of Singapore manufactures fashion jewelry, and sells it through sales affiliates in
Hong Kong, the United Kingdom, and the United States. For a recent month, the following payments matrix of
interaffiliate cash flows, stated in Singapore dollars, was forecasted. Show how Trendy Designs Company can
use multilateral netting to minimize the foreign exchange transactions necessary to settle interaffiliate
payments. If foreign exchange transactions cost the company .5 percent, what savings result from netting?

Disbursement
Receipts SINGAPORE HONG UK US TOT RECEPITS
KONG
SINGAPORE 40 75 55 170
HONG KONG 8 22 30
UK 15 17 32
US 11 25 9 45
TOT 34 65 84 94 277
DISBOURSEMENTS

Solution

BILATERAL NETTING:

- UK pays (75 15) = 60$ to Singapore

- Hong Kong pays (40 8) =32$ to Singapore
- Hong Kong pays(25-22) = 3$ to US
- US pays (17 9) = 8$ to UK
- US pays (55 11) = 44$ to Singapore

MULTILATERAL NETTING:

- US has to pay 8 + 44 3 =49$

- UK has to pay 60 8 = 52$
- Hong Kong has to pay 32 + 3 = 35$

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 - Singapore has to receive 60 + 32 + 44 = 136 = 49 + 52 + 35

By doing exchanges for 136,000$ instead of 277,000$, you save 141,000$ X 0.005 = $705

Ex 33 Chapter 19, Exercise 1

Assume the time from acceptance to maturity on a 50,000,000 bankers acceptance (B/A) is 90 days. Further
assume that the importing banks acceptance commission is 1.50 percent and that the market rate for 90-day
B/As is 6.50 percent. Determine the amount the exporter will receive if he holds the B/A until maturity and
also the amount the exporter will receive if he discounts the B/A with the importers bank.

Solution

The exporter will receive 49,812,500 = 50,000,000 x [1 - (.015 x 90/360)] if he holds the B/A to maturity. The
acceptance commission is 187,500. The exporter will receive 49,000,000 = 50,000,000 x [1 - ((.065 + .015) x
90/360)] if he discounts the B/A with the importers bank.