1 - The College of Business
Chapter 8
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| |Problem 8.4 Mattel Toys | |
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| |Advise Mattel on its European sales. | | | | | |
| |Assumptions | |Values | | | |
| |90-day A/R (€) | |€30,000,000.00 | | | |
| |Current spot rate (4/€) | |$1.2186 | | | |
| |Credit Suisse 90-day forward rate ($/€) | |$1.2170 | | | |
| |Barclays 90-day forward rate ($/€) | |$1.2210 | | | |
| |Expected spot rate in 90 days ($/€) | |$1.1800 | | | |
| |90-day eurodollar interest rate | |4.000% | | | |
| |90-day euro-euro interest rate | |4.400% | | | |
| | Implied 90-day forward rate (calculated, $/€) | |$1.2174 | | | |
| |90-day eurodollar borrowing rate | |5.600% | | | |
| |90-day euro-euro borrowing rate | |6.400% | | | |
| |Mattel Toys weighted average cost of capital ($) | |9.600% | | | |
| | | | | |Risk | |
| |Hedging Alternatives | |Values | |Assessment | |
| |1. Remain Uncovered, settling A/R in 90 days at market rate | | | |
| |(20 million euros/future spot rate) | | | | | |
| |If spot rate in 90 days is same as current | |$36,558,000.00 | |Risky | |
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| |If spot rate in 90 days is same as Credit Suisse forward rate | |$36,510,000.00 | |Risky | |
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| |If spot rate in 90 days is same as Barclays forward rate | |$36,630,000.00 | |Risky | |
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| |If spot rate in 90 days is expected spot rate | |$35,400,000.00 | |Risky | |
| |2. Sell euros forward 90 days | | | | | |
| |Settlement amount at Credit Suisse forward rate | |$36,510,000.00 | |Certain | |
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| |Settlement amount at Barclays forward rate | |$36,630,000.00 | |Certain | |
| |3. Money Market Hedge | | | | | |
| |Principal A/R in euros | |€30,000,000.00 | | | |
| |discount factor for euro borrowing rate for 90 days | |0.9843 | |1/(1 + (0.064 ( 90/360)) | |
| |Borrow euros against 90-day A/R | |€29,527,559.06 | | | |
| |Current spot rate, $/euro | |$1.2186 | | | |
| |US dollar current value | |$35,982,283.46 | | | |
| |Mattel’s WACC carry-forward factor for 90 days | |1.0240 | |1 + (0.0960 ( 90/360) | |
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| |Future value of money market hedge | |$36,845,858.27 | |Certain | |
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| |Evaluation of Alternatives | | | | | |
| |The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate| |
| |(carry-forward rate). | |
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| |Problem 8.5 Tek: Italian account receivable | |
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| |Hedging foreign exchange risk: a receivable | | | | | |
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| |Assumptions | |Values | | | |
| |Account receivable due in 3 months, in euros (€) | |€4,000,000.00 | | | |
| |Spot rate ($/(€) | |1.2000 | | | |
| |3-month forward rate ($/€) | |1.2180 | | | |
| |3-month euro interest rate | |4.200% | | | |
| |3-month put option on euros: | | | | | |
| | Strike rate ($/€) | |1.0800 | | | |
| | Premium, percent per year | |3.400% | | | |
| |Tek’s weighted average cost of capital | |9.800% | | | |
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| | | |a) | |b) | |
| |What are the costs and risk of each alternative? | |Value | |Certainty? | |
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| |1. Do nothing and exchange euros for dollars at end of 3 months | | | | | |
| |Amount of euro receivable | |€4,000,000.00 | | | |
| |If spot rate in 3 months is the same as the forward rate | |1.2180 | |Very uncertain; | |
| |US dollar proceeds of receivable would be | |$4,872,000.00 | |Risky | |
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| |Amount of euro receivable | |€4,000,000.00 | | | |
| |If spot rate in 3 months is the same as the current spot rate | |1.2000 | |Very uncertain; | |
| |US dollar proceeds of receivable would be | |$4,800,000.00 | |Risky | |
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| |2. Sell euro receivable forward at the 3-month forward rate | | | | | |
| |Amount of euro receivable | |€4,000,000.00 | | | |
| |forward rate | |1.2180 | |Certain; | |
| |US dollar proceeds of receivable would be | |$4,872,000.00 | |Locked-in | |
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| |Problem 8.5 Tek: Italian account receivable (Continued) | |
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| |3. Buy a put option on euros | | | | | |
| |Amount of euro receivable | |€4,000,000.00 | | | |
| |Current spot rate ($/euro) | |1.2000 | | | |
| |Premium on put option, % | |3.400% | | | |
| |Cost of put option (amount ( spot rate ( percent premium) | |$163,200.00 | | | |
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| |If the spot rate at end of 3-months is less than strike rate | | | |Minimum is | |
| |the option is exercised yielding gross dollars of | |$4,320,000.00 | |guaranteed; | |
| |Less cost of option (premium) plus US$interest on premium | |$(167,198.40) | |could be | |
| |Net proceeds of A/R if option is exercised (this is Minimum) | |$4,152,801.60 | |greater. | |
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| |Summary of Alternatives | |Value | |Certainty? | |
| |Do Nothing | |$4,800,000.00 | |Risky | |
| |Sell A/R forward | |$4,872,000.00 | |Certain | |
| |Buy Put Option | |$4,152,801.60 | |Minimum | |
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| |c) If Tek wishes to play it safe, it should lock in the forward rate. | | | | | |
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| |d) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view that the dollar | |
| |is going to depreciate versus the euro over the 3-month period, | |
| |past $1.20/€, then Tek might consider purchasing the put option on euros. | |
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| |Problem 8.6 Tek: Japanese account payable | |
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| |Hedging foreign exchange risk: a payable | | | | | |
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| |Assumptions | |Values | | | |
| |Account payable to Japan Sony-Tek, in Japanese yen (¥) | |8,000,000.00 | | | |
| |Spot rate (¥/$) | |108.20 | | | |
| |6-month forward rate (¥/$) | |106.20 | | | |
| |6-month yen deposit rate | |1.250% | | | |
| |6-month dollar interest rate | |4.000% | | | |
| |6-month call option on yen: | | | | | |
| | Strike rate (¥/$) | |108.00 | | | |
| | Premium, percent per year | |2.500% | | | |
| |Tek’s weighted average cost of capital | |9.800% | | | |
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| |What are the costs and risk of each alternative? | |a) Value | |b) Certainty | |
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| |1. Do nothing and exchange dollars for yen at end of 6 months | | | | | |
| |Amount of yen payable | |8,000,000.00 | | | |
| |If spot rate in 3 months is the same as the forward rate | |106.20 | |Very uncertain; | |
| |US dollar cost of settling payable would be | |$75,329.57 | |Risky | |
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| |Amount of yen payable | |8,000,000.00 | | | |
| |If spot rate in 3 months is the same as the current spot rate | |108.20 | |Very uncertain; | |
| |US dollar cost of settling payable would be | |$73,937.15 | |Risky | |
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| |2. Buy yen forward 6-months to lock in cost of settling payable | | | | | |
| |Amount of yen payable | |8,000,000.00 | | | |
| | forward rate | |106.20 | |Certain; | |
| |US dollar cost of settling payable would be | |$75,329.57 | |Locked-in | |
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| |Problem 8.6 Tek: Japanese account payable (Continued) | |
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| |3. Money market hedge—invest funds in yen deposit now | | | | | |
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| |Principal needed at the end of 6-months, yen | |8,000,000 | | | |
| |Discount factor, 6-months @ yen deposit rate | |0.9938 | |1/(1 + (0.0125 ( 180/360)) | |
| |Yen deposit needed, now | |7,950,311 | | | |
| |Current spot rate (¥/$) | |108.20 | | | |
| |US dollars needed now, for exchange into yen | |$73,477.92 | | | |
| |Carry-forward rate, 6 months @ Tek’s WACC | |1.05 | |1 + (0.0980 ( 180/360) | |
| |US cost of money market hedge at end of 6-months | |$77,078.33 | | | |
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| |4. Buy a call option on Japanese yen | | | | | |
| |Amount of yen payable | |8,000,000.00 | | | |
| |Current spot rate (¥/$) | |108.20 | | | |
| |Premium on call option, % | |2.500% | | | |
| |Cost of call option | |$1,848.43 | | | |
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| |If the spot rate at end of 3-months is greater than strike rate | | | |Maximum cost | |
| |the option is exercised yielding gross dollars of | |$74,074.07 | |guaranteed; | |
| |Plus cost of option (premium) plus US$interest on premium | |$1,939.00 | |could be | |
| |Total cost of exercising call option on yen | |$76,013.08 | |less. | |
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| |Summary of Alternatives: Cost of settling A/P | |Value | |Certainty? | |
| |Do Nothing | |$73,937.15 | |Risky | |
| |Buy yen forward | |$75,329.57 | |Certain | |
| |Deposit yen now (money market hedge) | |$77,078.33 | |Certain | |
| |Buy call option on yen | |$76,013.08 | |Maximum | |
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| |c) If Tek wishes to take a reasonable risk (definining ‘reasonable’ is another issue), and has a directional view that the yen may be| |
| |depreciating (falling) versus the dollar over the coming 6-month period, somewhere below the option strike rate of ¥108/$, then Tek | |
| |might consider purchasing the call option. If Tek is a bit more risk adverse, the forward rate is relatively attractive compared to | |
| |the money market hedge. | |
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| |Problem 8.7 Tek: British Telecom bidding | |
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| |Hedging foreign exchange risk of a contract bid | | | | | |
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| |Assumptions | |Values | | | |
| |Account receivable of bid, supply & install (British pounds, £) | |£1,500,000 | | | |
| |Spot rate ($/£) | |1.8418 | | | |
| |Tek’s weighted average cost of capital | |9.800% | | | |
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| | | |1-month | |4-month | |
| |Forward rate ($/£) | |1.8368 | |1.8268 | |
| |British pound investment rate | |4.000% | |4.125% | |
| |British pound borrowing rate | |6.500% | |6.500% | |
| |Put option on pound: | | | | | |
| | Strike rate ($/£) | |1.85 | |1.85 | |
| | Premium ($/£) | |$0.006 | |$0.012 | |
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| |Analysis and Evaluation | |a) Value | |b) Certainty | |
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| |If Tek wins the bid, it will be long foreign currency, having a 1.5 million | | | | |
| |pound position which is first backlog then an A/R. | | | | | |
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| |If and when Tek is awarded the bid, it would have 4 months (120 days) | | | | |
| |until cash settlement of the 1 million pound position. | | | | | |
| |1. Do Nothing—Remaining Uncovered | | | | | |
| |Wait 120 days and exchange pounds for dollars spot | | | | | |
| |If the ending spot rate is the same as current spot rate | |$2,762,700.00 | |Risky | |
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| |If the ending spot rate is the same as the 4-month forward rate | |$2,740,200.00 | |Risky | |
| |It could, however, be much lower. | | | | | |
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| |2. Sell the pounds forward | | | | | |
| |Selling 1 million pounds forward at the 4-month forward rate | |$2,740,200.00 | |Certain Value | |
| |The primary problem with this is that if Tek does not win the bid, | | | |If Tek Wins Bid | |
| |it has a forward contract to sell pounds which it will not earn. | | | | | |
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| |3. Money market hedge—borrow against expected receipts | | | | | |
| |Expected receipts (£) | |£1,500,000 | | | |
| |Discount factor for 4-months at pound borrowing rate | |0.9788 | |1/(1+ (0.065 ( 120/360)) | |
| |Proceeds from borrowing, now (£) | |£1,468,189 | | | |
| |Current spot rate ($/£) | |1.8418 | | | |
| |Proceeds from borrowing, now ($) | |$2,704,110.93 | | | |
| |Carry-forward rate, 4 months @ Tek’s WACC | |1.0327 | |1 + (0.098 ( 120/360) | |
| |Value in 4 months of money market hedge ($) | |$2,792,445.22 | | | |
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| |4. Buy a put option on pounds at strike price of 1.85 | | | | | |
| |Option, if exercised (if ending spot rate less than $1.85) | |$2,775,000.00 | | | |
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| |Put option premium, up-front | |$18,000.00 | | | |
| |and the 4-months opportunity cost of premium | |588.00 | | | |
| |Total premium expense | |$18,588.00 | | | |
| | | | | |Minimum; | |
| |Minimum dollars received if put option purchased | |$2,756,412.00 | |Could be More | |
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| |The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid’s award. The advantage of the option is if Tek | |
| |does not win the bid, the option can easily be sold. | |
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| |Problem 8.8 Tek—Swedish price list | |
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| |Hedging foreign currency price quotes and potential sales. | | | | | |
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| |Assumptions | |Values | | | |
| |Expected sale over 90-day period, Swedish krona (SKr) | |5,000,000.00 | | Could be more | |
| |Spot rate (SKr/$) | |7.4793 | | | |
| |90-day forward rate (SKr/$) | |7.4937 | | | |
| |3-month dollar interest rate | |4.000% | | | |
| |3-month krona deposit interest rate | |4.780% | | | |
| |3-month krona borrowing interest rate | |6.500% | | | |
| |3-month put option on krona: | | | | | |
| | Strike rate (SKr/$) | |7.50 | | | |
| | Premium | |2.500% | | | |
| |Tek’s weighted average cost of capital | |9.800% | | | |
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| |Hedging Alternatives | | | | | |
| |This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of |
| |sales will occur, and therefore what Tek’s actual long position in Swedish krona will be. | |
| | | |Value | |Certainty? | |
| |1. Do Nothing—Remain Uncovered. | | | | | |
| |The ending spot rate at the time of settlement | | | | | |
| |could be nearly anything. | | | | | |
| |If the ending spot rate is the same as current spot rate (SKr/$) | |$668,511.76 | |Risky | |
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| |If the ending spot rate is the same as forward (SKr/$) | |$667,227.14 | |Risky | |
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| |2. Sell Swedish krona forward | | | | | |
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| |Sold forward 3-months at forward rate (SKr/$) | |$667,227.14 | |Certain | |
| |However, remember that Tek does not know total sales. | | | | | |
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| |Problem 8.8 Tek—Swedish price list (Continued) | |
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| |3. Money market hedge | | | | | |
| | Tek would borrow now against expected proceeds of (SKr) | |5,000,000.00 | | | |
| |Discount rate of SKr interest rate for 90-days | |0.98401 | | | |
| |SKr proceeds from borrowing received up-front | |4,920,049.20 | | | |
| |Exchanged at current spot rate (SKr/$) | |7.48 | | | |
| |US dollars received now | |$657,822.15 | | | |
| |Tek carry-forward rate for US$for 90 days | |1.025 | | | |
| |Money market hedge proceeds in 90-days | |$673,938.79 | | | |
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| |4. Buy a 3-month put option on Swedish krona | |If exercised | |If not exercised | |
| | Proceeds will be option less premium if exercised (minimum) | | | |(random choice) | |
| |Exchange rate if exercised/not exercised (SKr/$) | |7.50 | |7.24 | |
| |Amount of Swedish krona | |5,000,000.00 | |5,000,000.00 | |
| |If exercised, it will yield a gross dollar amount of | |$666,666.67 | |$690,607.73 | |
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| |Put option premium | |$16,712.79 | |$16,712.79 | |
| |Opportunity cost of premium | |409.46 | |409.46 | |
| |Total future value of premium | |$17,122.26 | |$17,122.26 | |
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| |Minimum net dollar proceeds at end of 90 days | |$649,544.41 | |$673,485.48 | |
| |(exercised gross amount less future value of premium) | |Minimum | | | |
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| |The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in | |
| |relative value arising from carrying-forward the dollars at Tek’s WACC.) | |
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| |If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to | |
| |about SKr7.24 (shown above) in order for the put option to yield roughly the same amount of US dollars as the money market | |
| |hedge. | |
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| |Problem 8.9 Tek: Swiss dividend payable | |
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| |Hedging an intra-company dividend payment. | | | | | |
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| |Assumptions | |Values | | | |
| |Dividend declared, Swiss francs (SFr) | |SFr. 5,000,000 | | | |
| |Spot rate (SFr/$) | |1.2462 | | | |
| |90-day forward rate (SFr/$) | |1.2429 | | | |
| |3-month US dollar interest rate | |4.000% | | | |
| |3-month Swiss franc interest rate | |3.750% | | | |
| |3-month put option on Swiss francs: | | | | | |
| | Strike rate (SFr/$) | |1.25 | | | |
| | Premium ($/SFr) | |$0.015 | | | |
| |Tek’s weighted average cost of capital | |9.80% | | | |
| |Tek’s expected spot rate in 90 days (SFr/$) | |1.22 | | | |
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| |Hedging Alternatives | |Value | |Certainty? | |
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| |1. Do Nothing—Remain Uncovered. | | | | | |
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| |If the ending spot rate is the same as current spot rate (SFr/$) | |$4,012,197.08 | |Risky | |
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| |If the ending spot rate is the same as forward (SKr/$) | |$4,022,849.79 | |Risky | |
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| |Realistically, the ending spot rate could vary between SFr1 and SFr2 per $. | | | |
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| |2. Sell Swiss francs forward | | | | | |
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| |Sold forward 3-months at forward rate (SFr/$) | |$4,022,849.79 | |Certain | |
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| |Problem 8.9 Tek: Swiss dividend payable (Continued) | |
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| |3. Money Market Hedge | | | | | |
| |Borrow SFr now against future receipt | | | | | |
| |Principal | |SFr. 5,000,000 | | | |
| |Borrow SFr at SFr interest rate for 90-days | |0.9907 | | | |
| |SFr proceeds received now via borrowing | |SFr. 4,953,560 | | | |
| |Exchanged into US$at spot rate of (SFr/$) | |1.25 | | | |
| |Dollars received now | |$3,974,932.09 | | | |
| |Carry-forward rate for US$at Tek’s WACC for 90-days | |1.0245 | | | |
| |Money Market Hedged proceeds in 90 days | |$4,072,317.93 | | | |
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| |4. Buy a 3-month put option on Swiss francs | |If exercised | |If not exercised | |
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| |Proceeds ’ option – premium, if exercised (minimum) | | | | | |
| |Effective exchange rate if exercised/not exercised, SFr/$ | |1.25 | |1.22 | |
| |Principal of payment, SFr | |SFr. 5,000,000 | |SFr. 5,000,000 | |
| |If exercised, it will yield a gross dollar amount of | |$4,000,000.00 | |$4,098,360.66 | |
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| |Put option premium | |$75,000.00 | |$75,000.00 | |
| |Opportunity cost of premium | |1,837.50 | |1,837.50 | |
| |Total future value of premium | |$76,837.50 | |$76,837.50 | |
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| |Minimum net dollar proceeds at end of 90 days | |$3,923,162.50 | |$4,021,523.16 | |
| |(exercised gross amount less future value of premium) | |Minimum | | | |
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| |Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some | |
| |degree of currency risk, and believes in the direciton of a stronger SFr, it may choose the 3-month put option. Note | |
| |that the official expectation is SFr1.22/$. This is still not superior to the Money Market Hedge. (The ending spot rate| |
| |would need to be SFr1.20/$or stronger to end up superior to the Money Market Hedge.) | |
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| |Assumptions | |
| |Northern Rainwear is receiving foreign currency, DKr, at future dates (“long DKr”). | | | |
| |Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD. | | | | |
| |Required Forward Cover for Northern: | |0–90 days | |91–180 days | |
| |Problem 8.11 Vamo Road Industries | |
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| |Hedging foreign exchange risk: a payable | | | | | |
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| |Assumptions | |Values | | | |
| |Construction payment due in six-months (A/P, quetzals) | |8,400,000 | | | |
| |Present spot rate (quetzals/$) | |7.0000 | | | |
| |Six-month forward rate (quetzals/$) | |7.1000 | | | |
| |Guatemalan six-month interest rate (per annum) | |14.000% | | | |
| |U.S. dollar six-month interest rate (per annum) | |6.000% | | | |
| |Vamo’s weighted average cost of capital (WACC) | |20.000% | | | |
| |Expected spot rate in six-months (quetzals/$): | | | | | |
| | Highest expected rate | |8.0000 | | | |
| | Expected rate | |7.3000 | | | |
| | Lowest expected rate | |6.4000 | | | |
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| |a) What realistic alternatives are available to Vamo? | |Cost | |Certainty | |
| |1. Wait six months and make payment at spot rate | | | | | |
| | | | | | | |
| |Highest expected rate | |$1,050,000.00 | |Risky | |
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| |Expected rate | |$1,150,684.93 | |Risky | |
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| |Lowest expected rate | |$1,312,500.00 | |Risky | |
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| |2. Purchase quetzals forward six-months | |$1,183,098.59 | |Certain | |
| |(A/P divided by the forward rate) | | | | | |
| | | | | | | |
| |3. Transfer dollars to quetzals today, invest for six-months | | | | | |
| |quetzals needed today (A/P discounted 180 days) | |7,850,467.29 | | | |
| |Cost in dollars today (quetzals to $at spot rate) | |$1,121,495.33 | | | |
| |factor to carry dollars forward 180 days (1 + (WACC/2)) | |1.10 | | | |
| |Cost in dollars in six-months ($carried forward 180 days ) | |$1,233,644.86 | |Certain | |
| | | | | | | |
| |The second choice, the forward contract, results in the lowest cost alternative among | |
| |certain alternatives. | |
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| |Problem 8.12 Worldwide Travel’s acquisition | |
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| |Hedging foreign exchange risk: a payable | | | | | |
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| |Assumptions | |Values | | | |
| |Acquisition price & 3-month A/P, NewTaiwan dollars (T$) | |7,000,000 | | | |
| |Spot rate (T$/$) | |33.40 | | | |
| |3-month forward rate (T$/$) | |32.40 | | | |
| |3-month Taiwan dollar deposit rate | |1.500% | | | |
| |3-month dollar borrowing rate | |6.500% | | | |
| |3-month call option on T$ | |not available | | | |
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| |Evaluation of Alternatives | |Cost | |Certainty | |
| | | | | | | |
| |1. Do Nothing—Wait 3 months and buy T$spot | | | | | |
| | | | | | | |
| |If spot rate is the same as current spot rate | |$209,580.84 | |Risky | |
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| |If spot rate is the same as 3-month forward rate | |$216,049.38 | |Risky | |
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| |Although this would do nothing to cover the currency risk, | | | |
| |there would be no required payment or borrowing for 3-months. | | | |
| | | | | | | |
| |2. Buy T$forward 3-months | | | | | |
| | | | | | | |
| |Assured cost of T$at 3-month forward rate | |$216,049.38 | |Certain | |
| | | | | | | |
| |The purchase of a forward contract would not require any cash | | | | | |
| |up-front, but the Bank of Hawaii would reduce his available credit | | | | |
| |line by the amount of the forward. This is a non-cash expense. | | | | | |
| |3. Money Market Hedge: Exchanging US$for T$now, depositing for 3-months until payment |
| | | | | | | |
| |Acquisition price in T$needed in 3-months | |7,000,000 | | | |
| |Discounted back 3-months at T$deposit rate | |0.9963 | | | |
| |Amount of NT$needed now for deposit | |6,973,848 | | | |
| |Spot rate, T$/$ | |33.40 | | | |
| |US$needed now for exchange | |$208,797.85 | | | |
| | | | | | | |
| |US$carry-forward rate (3-month dollar borrowing rate) | |6.500% | |Certain | |
| |Carry-forward factor of US$for 3-month period | |1.0163 | | | |
| |Total cost in US$of settling A/P in 3-months with | |$212,190.81 | | | |
| |Money Market Hedge | | | | | |
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| |The currency risk is eliminated, but since Matt Morita would have to exchange the money up-front, it requires Matt | |
| |Morita to increase his debt outstanding for the entire 3 months. | |
| | | |
| |Forward contract hedge is probably the best “acceptable” alternative. | | | |
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| |Problem 8.13 Seattle Scientific, Inc. | |
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| |Costs and benefits of cash versus cover. | | | |
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| |Assumptions | |Values | |
| |Seattle’s 30-day account receivable, Japanese yen | |12,500,000 | |
| |Spot rate, yen/$ | |120.23 | |
| |30-day forward rate, yen/$ | |119.73 | |
| |90-day forwrad rate, yen/$ | |118.78 | |
| |180-day forward rate, yen/$ | |117.21 | |
| |Yokasa’s WACC | |8.850% | |
| |Seattle Scientific’s WACC | |12.500% | |
| |Desired discount on purchase price by Yokasa | |4.500% | |
| | | | | |
| |Josh Miller should compare two basic alternatives, both of which eliminate the currency risk. |
| | | | | |
| |1. Allow the discount and receive payment in Japanese yen in cash | | | |
| | | | | |
| |Account recievable (yen) | |12,500,000 | |
| |Discount for cash payment up-front (4.500%) | |(562,500) | |
| |Amount paid in cash net of discount | |11,937,500 | |
| | | | | |
| |Current spot rate | |120.23 | |
| |Amount received in U.S. dollars by Seattle Scientific | |$99,288.86 | |
| | | | | |
| |2. Not offer any discounts for early payment and cover exposure with forwards | |
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| |Account receivable (yen) | |12,500,000 | |
| |30-day forward rate | |119.73 | |
| |Amount received in cash in dollars, in 30 days | |$104,401.57 | |
| | | | | |
| |Discount factor for 30 days @ Seattle’s WACC | |0.9897 | |
| |Present value of dollar cash received | |$103,325.27 | |
| | | | | |
| |Josh Miller should politely decline Yokasa’s offer to pay cash in exchange for cash payment. | |
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| |Problem 8.14 Wilmington Chemical Company | |
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| |Hedging foreign exchange risk: a payable | | | | | |
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| |Assumptions | |Values | | | |
| |Shipment of phosphates from Morocco, Moroccan dirhams | |6,000,000 | | | |
| |Wilmington’s cost of capital (WACC) | |14.000% | | | |
| |Spot exchange rate, dirhams/$ | |10.00 | | | |
| |Six-month forward rate, dirhams/$ | |10.40 | | | |
| | | | | | | |
| |Options on Moroccan dirhams: | |Call Option | |Put Option | |
| | Strike price, dirhams/$ | |10.00 | |10.00 | |
| | Option premium (percent) | |2.000% | |3.000% | |
| | | | | | | |
| | | |United States | |Morocco | |
| |Six-month interest rate for borrowing (per annum) | |6.000% | |8.000% | |
| |Six-month interest rate for investing (per annum) | |5.000% | |7.000% | |
| | | | | | | |
| |Risk Management Alternatives | |Values | |Certainty | |
| | | | | | | |
| |1. Remain uncovered, making the dirham payment in six months | | | | | |
| |at the spot rate in effect at that date | | | | | |
| |Account payable (dirhams) | |6,000,000 | | | |
| |Possible spot rate in six months—the current spot rate (dirhams/$) | |10.00 | | | |
| |Cost of settlement in six months (US$) | |$600,000.00 | |Uncertain. | |
| | | | | | | |
| |Account payable (dirhams) | |6,000,000 | | | |
| |Possible spot rate in six months—forward rate (dirhams/$) | |10.40 | | | |
| |Cost of settlement in six months (US$) | |$576,923.08 | |Uncertain. | |
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| |Problem 8.14 Wilmington Chemical Company (Continued) | |
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| |2. Forward market hedge. Buy dirhams forward six months. | | | | | |
| | | | | | | |
| |Account payable (dirhams) | |6,000,000 | | | |
| |Six month forward rate, dirhams/$ | |10.40 | | | |
| |Cost of settlement in six months (US$) | |$576,923.08 | |Certain. | |
| | | | | | | |
| |3. Money market hedge. Exchange dollars for dirhams now, invest for six months. | | | |
| |Account payable (dirhams) | |6,000,000.00 | | | |
| |Discount factor at the dirham investing rate for 6 months | |1.035 | | | |
| |Dirhams needed now for investing (payable/discount factor) | |5,797,101.45 | | | |
| |Current spot rate (dirhams/$) | |10.00 | | | |
| |US dollars needed now | |$579,710.14 | | | |
| |Carry forward rate for six months (WACC) | |1.070 | | | |
| |US dollar cost, in six months, of settlement | |$620,289.86 | |Certain. | |
| | | | | | | |
| |4. Call option hedge. (Need to buy dirhams ’ call on dirhams) | | | | | |
| |Option principal | |6,000,000.00 | | | |
| |Current spot rate, dirhams/$ | |10.00 | | | |
| |Premium cost of option | |2.000% | | | |
| |Option premium (principal/spot rate ( % pm) | |$12,000.00 | | | |
| | | | | | | |
| |If option exercised, dollar cost at strike price of 10.00 dirhams/$ | |$600,000.00 | | | |
| |Plus premium carried forward six months (pm ( 1.07, WACC) | |12,840.000 | | | |
| |Total net cost of call option hedge if exercised | |$612,840.00 | |Maximum. | |
| | | | | | | |
| |The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to depreciate significantly over the| |
| |next six months, it may choose the call option. | |
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| |Problem 8.15 Dawg-Grip, Inc. | |
| | | | | | | |
| |Hedging foreign exchange risk: a payable | | | | | |
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| |Assumptions | |Values | | | |
| |Purchase price of Korean manufacturer, in Korean won | |7,030,000,000 | | | |
| |Less initial payment, in Korean won | |(1,000,000,000) | | | |
| |Net settlement needed, in Korean won, in six months | |6,030,000,000 | | | |
| |Current spot rate (Won/$) | |1,200 | | | |
| |Six month forward rate (Won/$) | |1,260 | | | |
| |Plasti-Grip’s cost of capital (WACC) | |25.00% | | | |
| | | | | | | |
| |Options on Korean won: | |Call Option | |Put Option | |
| | Strike price, won | |1,200.00 | |1,200.00 | |
| | Option premium (percent) | |3.000% | |2.400% | |
| | | | | | | |
| | | |United States | |Korea | |
| |Six-month investment interest rate (per annum) | |4.000% | |16.000% | |
| |Six-month borrowing rate (investment rate + 2%) | |6.000% | |18.000% | |
| | | | | | | |
| |Risk Management Alternatives | |Values | |Certainty | |
| | | | | | | |
| |1. Remain uncovered, making the won payment in 6 months | | | | | |
| |at the spot rate in effect at that date | | | | | |
| |Account payable (won) | |6,030,000,000 | | | |
| |Possible spot rate in six months: current spot rate (won/$) | |1,200 | | | |
| |Cost of settlement in six months (US$) | |$5,025,000.00 | |Uncertain. | |
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| |Account payable (won) | |6,030,000,000 | | | |
| |Possible spot rate in six months: forward rate (won/$) | |1,260 | | | |
| |Cost of settlement in six months (US$) | |$4,785,714.29 | |Uncertain. | |
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| |Problem 8.15 Dawg-Grip, Inc. (Continued) | |
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| |2. Forward market hedge. Buy won forward six months | | | | | |
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| |Account payable (won) | |6,030,000,000 | | | |
| |Forward rate (won/$) | |1,260.00 | | | |
| |Cost of settlement in six months (US$) | |$4,785,714.29 | |Certain. | |
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| |3. Money market hedge. Exchange dollars for won now, invest for six months. | | | |
| |Account payable (won) | |6,030,000,000 | | | |
| |Discount factor at the won interest rate for 6 months | |1.080 | | | |
| |Won needed now (payable/discount factor) | |5,583,333,333.33 | | | |
| |Current spot rate (won/$) | |1,200.00 | | | |
| |US dollars needed now | |$4,652,777.78 | | | |
| |Carry forward rate for six months (WACC) | |1.125 | | | |
| |US dollar cost, in six months, of settlement | |$5,234,375.00 | |Certain. | |
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| |4. Call option hedge. (Need to buy won ’ call on won) | |If exercised | |If not exercised | |
| |Option principal | |6,030,000,000 | | | |
| |Current spot rate (won/$) | |1,200.00 | |1,307.00 | |
| |Premium cost of option (%) | |3.000% | | | |
| |Option premium (principal/spot rate ( % pm) | |$150,750.00 | | | |
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| |If option exercised/not exercised, dollar cost of won | |$5,025,000.00 | |$4,613,618.97 | |
| |Premium carried forward six months (pm ( 1.125, WACC) | |169,593.750 | |169,593.75 | |
| |Total net cost of call option hedge if exercised | |$5,194,593.75 | |$4,783,212.72 | |
| | | |Maximum. | | | |
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| |The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes | |
| |the ending spot rate will be Won 1307/$or higher, the call option hedge could prove lower cost. This would require the | |
| |firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event | |
| |their spot rate expectations proved incorrect. | | | | | |
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| |Problem 8.16 Aqua-Pure | |
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| |Hedging foreign exchange risk: a receivable | | | | | |
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| |Assumptions | |Values | | | |
| |Amount of receivable, Japanese yen | |20,000,000 | | | |
| |Spot exchange rate at time of sale (yen/$) | |118.255 | | | |
| | Booked value of sale (amount/spot rate) | |$169,126.04 | | | |
| |Days receivable due | |90 | | | |
| |Aqua-Pure’s WACC | |16.0% | | | |
| |Competitor borrowing premium, yen | |2.0% | | | |
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| |Forward rates and premiums | |Forward Rate | |Premium | |
| |One-month forward rate (yen/$) | |117.760 | |5.04% | |
| |Three-month forward rate (yen/$) | |116.830 | |4.88% | |
| |One-year forward rate (yen/$) | |112.450 | |5.16% | |
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| |Investment rates, % per annum | |United States | |Japan | |
| |1 month | |4.8750% | |0.09375% | |
| |3 months | |4.9375% | |0.09375% | |
| |12 months | |5.1875% | |0.31250% | |
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| |Purchased options | |Strike (yen/$) | |Premium | |
| |3-month call option on yen | |118.000 | |1.0% | |
| |3-month put option on yen | |118.000 | |3.0% | |
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| |Problem 8.16 Aqua-Pure (Continued) | |
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| |a. Alternative Hedges | |Values | |Certainty | |
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| |1. Remain uncovered. | | | | | |
| |Account receivable (yen) | |20,000,000 | | | |
| |Possible spot rate in 90 days (yen/$) | |118.255 | | | |
| |Cash settlement in 90 days (US$) | |$169,126.04 | |Uncertain. | |
| |2. Forward market hedge. | | | | | |
| |Account receivable (yen) | |20,000,000 | | | |
| |Forward rate (won/$) | |116.830 | | | |
| |Cash settlement in 90 days (US$) | |$171,188.91 | |Certain. | |
| |3. Money market hedge. | | | | | |
| |Account receivable (yen) | |20,000,000 | | | |
| |Discount factor for 90 days | |1.00523 | |1 + ((0.0009375 + .02) ( 90/360) | |
| |Yen proceeds up front | |19,895,858 | | | |
| |Current spot rate (won/$) | |118.255 | | | |
| |US dollars received now | |$168,245.38 | | | |
| |Carry forward at Aqua-Pure’s WACC | |1.0400 | |1 + (0.16 ( 90/360) | |
| |Proceeds in 90 days | |$174,975.20 | |Certain. | |
| |4. Put option hedge. (Need to sell yen ’ put on yen) | | | | | |
| |Option principal | |20,000,000 | | | |
| |Current spot rate (won/$) | |118.255 | | | |
| |Premium cost of option (%) | |3.000% | | | |
| |Option pm (principal/spot rate ( % pm) | |$5,073.78 | | | |
| |If option exercised, dollar proceeds | |$169,491.53 | | | |
| |Less Pm carried forward 90 days | |(5,276.732) | |1.04 carry-forward rate | |
| |Net proceeds in 90 days | |$164,214.79 | |Minimum. | |
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| |The put option does not GUARANTEE the company of settling for the booked amount. | |
| |The money market and forward hedges do; the money market yielding the higher proceeds. | |
| |b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate: | |
| |Money market, US$up-front | |$168,245.38 | | | |
| |Forward contract, US$, end of 90 days | |$171,188.91 | | | |
| |(1 + x) | |101.750% | |$168,245 (1 + x) ’ $171,189 | |
| |x | |1.74954% | |For 90 days | |
| |Breakeven rate, % per annum | |6.998% | | | |
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| |Problem 8.17 Botox Watch Company | |
| |Hedging policy | | | | | |
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| |Assumptions | |Values | | | |
| |Account recievable in 90 days (€) | |1,560,000 | | | |
| |Initial spot exchange rate ($/€) | |$1.2340 | | | |
| |Forward rate, 90 days ($/€) | |$1.2460 | | | |
| |Expected spot rate in 90 to 120 days ($/€): Case #1 | |$1.2000 | | | |
| |Expected spot rate in 90 to 120 days ($/€): Case #2 | |$1.2600 | | | |
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| | | |Hedged | |Hedged | |
| |If Botox Watch Company …… | |the Minimum | |the Maximum | |
| |Proportion of exposure to be hedged | |70% | |120% | |
| |Total exposure (€) | |1,560,000 | |1,560,000 | |
| |hedged proportion | |70% | |120% | |
| |Minimum hedge in euros (exposure ( min prop) | |1,092,000 | |1,872,000 | |
| |at the forward rate ($/€) | |$1.2460 | |$1.2460 | |
| |locking in ($) | |$1,360,632 | |$2,332,512 | |
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| |Case #1: Ending spot rate | | | | | |
| |Proportion uncovered (short) | |468,000 | |(312,000) | |
| |If ending spot rate is ($/€) | |$1.2000 | |$1.2000 | |
| |Value of uncovered proportion ($) | |$561,600 | |$(374,400) | |
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| |Value of covered proportion (from above) | |$1,360,632 | |$2,332,512 | |
| |Total net proceeds, covered + uncovered | |$1,922,232 | |$1,958,112 | |
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| |Case #2: Ending spot rate | | | | | |
| |Proportion uncovered (short) | |468,000 | |(312,000) | |
| |If ending spot rate is ($/€) | |$1.2600 | |$1.2600 | |
| |value of uncovered proportion ($) | |$589,680 | |$(393,120) | |
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| |Value of covered position (from above) | |$1,360,632 | |$2,332,512 | |
| |Total net proceeds, covered + uncovered | |$1,950,312 | |$1,939,392 | |
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| |Benchmark: Full (100%) forward cover | |$1,943,760 | |$1,943,760 | |
| |This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for| |
| |more than the exposure (therefore creating a net short position) the firm could experience nearly unlimited losses or gains. | |
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| |If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to | |
| |take the currency risk, the put option hedges could be considered. | | | | |
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| |is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement, | |
| |the difference being the foreign exchange gain (loss). | |
| |many firms do not define an “exposure” as arising until the date that the product is shipped (loss of physical control over | |
| |the goods) and the sale is booked on the income statement, that is a common date for the purchase of the forward contract. | |
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| |in Pixel’s US dollar settlement amount a full 90 days earlier in the transaction exposure’s life span. | | | | |
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| |have been even greater, although “fully hedged.” The difference is of course the result of the forward rate changing with spot rates | |
| |and interest differentials. | | | | | |
| |Problem 8.20 Maria Gonzalez and Trident (A) | | | | | |
| |90-day A/R in pounds | |3,000,000 | | | |
| |Spot rate, US$per pound | |1.7620 | | | |
| |90-day forward rate, US$per pound | |1.7550 | | | |
| |3-month U.S. dollar investment rate | |6.000% | | | |
| |3-month U.S. dollar borrowing rate | |8.000% | | | |
| |3-month UK investment interest rate | |8.000% | | | |
| |3-month UK borrowing interest rate | |14.000% | | | |
| |Put options on the British pound: Strike rates, US$/pound | |1.75 | |1.71 | |
| | Put option premium | |1.500% | |1.000% | |
| |Trident’s WACC | |12.000% | | | |
| |Maria Gonzalez’s expected spot rate in 90-days, US$per pound | |1.7850 | | | |
| |Alternative #1: Remain Uncovered | |Rate ($/pound) | |Proceeds | |
| |Value of A/R will be (3 million pounds ( ending spot rate ($/pound)) | | | | | |
| |If spot rate is the same as current spot rate | |$1.7620 | |$5,286,000.00 | |
| |If ending spot rate is the same as current forward rate | |$1.7550 | |$5,265,000.00 | |
| |If ending spot rate is the expected spot rate | |$1.7850 | |$5,355,000.00 | |
| |Alternative #2: Forward Contract Hedge | |Rate ($/pound) | |Proceeds | |
| |Sell the pounds forward 3-months locking in the forward rate | | | | | |
| |Pound A/R at the forward rate (pounds ( forward) | |$1.7550 | |$5,265,000.00 | |
| |Alternative #3: Money Market Hedge | |Rate ($/pound) | |Proceeds | |
| |Trident borrows against the A/R, receiving pounds up-front, exchanging into US$. | | | |
| |Amount of A/R in 90-days, in pounds | | | |3,000,000.00 | |
| |Discount factor, pound borrowing rate, for 3-months | | | |0.9662 | |
| |Proceeds of borrowing, up-front, in pounds | | | |2,898,550.72 | |
| |Exchanged to US$at current spot rate of | |$1.7620 | | | |
| |US$received against A/R, up-front | | | |$5,107,246.38 | |
| |US$need to be carried forward for comparison: | | | | | |
| |Carry-forward rate, WACC for 90-days | | | |1.0300 | |
| |Money Market Hedge, US$, at end of 90-days | | | |$5,260,463.77 | |
| | | | | |(Continued) | |
| | | | | | | |
| | | | | | | |
| |Problem 8.20 Maria Gonzalez and Trident (A) (Continued) | | | | | |
| | | |Strike Rate ($/pnd) | |Strike Rate ($/pnd) | |
| |Alternative #4: Put Option Hedges | |1.75 | |1.71 | |
| |Option premium | |1.500% | |1.000% | |
| |Notional principal of option (pounds) | |3,000,000 | |3,000,000 | |
| |Spot rate ($/pound) | |1.7620 | |1.7620 | |
| |Option premium, US$ | |$79,290.00 | |$52,860.00 | |
| |Carry-forward factor, WACC, for 90-days | |1.0300 | |1.0300 | |
| |Total premium cost, in 90-days | |$81,668.70 | |$54,445.80 | |
| | | | | | | |
| |Proceeds from put option if exercised | |$5,250,000.00 | |$5,130,000.00 | |
| |Less cost of premium, including time-value | |(81,668.70) | |(54,445.80) | |
| |Net proceeds from put options, in 90-days: Minimum | |$5,168,331.30 | |$5,075,554.20 | |
| | | | | | | |
| |Ending spot rate needed to be superior to forward: | |$1.7825 | |$1.7732 | |
| |Proceeds from exchanging pounds for US$spot | |$5,347,500.00 | |$5,319,600.00 | |
| |Less cost of option (allowed to expire OTM) | |(81,668.70) | |(54,445.80) | |
| |Net proceeds from put option, unexercised | |$5,265,831.30 | |$5,265,154.20 | |
| | | | | | | |
| |Analysis: Maria Gonzalez would receive the most certain US$from the forward contract, $5,265,000; the money market hedge is less attractive as result of | |
| |the higher borrowing costs in the UK now. The two put options yield unattractive amounts if they had to be exercised. As shown, the $1.75 strike price | |
| |put option would be superior to the forward if the ending spot rate was $1.7825 or higher; the $1.71 strike price would be superior to the forward if the| |
| |ending spot rate were $1.7732 or higher. | |
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| |Problem 8.22 Siam Cement | | | |
| | | | | |
| |Assumptions | |Value | |
| |US dollar debt taken out in June 1997 | |$50,000,000 | |
| |US dollar borrowing rate on debt | |8.400% | |
| |Initial spot exchange rate, baht/dollar, June 1997 | |25.00 | |
| |Average spot exchange rate, baht/dollar, June 1998 | |42.00 | |
| | | | | |
| |Calculation of Foreign Exhange Loss on Repayment of Loan | | | |
| | | | | |
| |At the time the loan was acquired, the scheduled repayment of dollar | | | |
| |and baht amounts would have been as follows: | | | |
| | | | | |
| |Scheduled Repayment: | | | |
| |Repayment of US dollar debt: Principal | |$50,000,000 | |
| |Repayment of US dollar debt: Interest | |4,200,000 | |
| | Total repayment | |$54,200,000 | |
| | | | | |
| |Exchange rate at time of repayment, baht/dollar | |25.00 | |
| | Total repayment in Thai baht | |1,355,000,000 | |
| | Total proceeds from loan, up-front, in Thai baht | |1,250,000,000 | |
| | Net interest to be paid, in Thai baht | |105,000,000 | |
| | | | | |
| |Actual Repayment: | | | |
| |Repayment of US dollar debt: Principal | |$50,000,000 | |
| |Repayment of US dollar debt: Interest | |4,200,000 | |
| | Total repayment | |$54,200,000 | |
| | | | | |
| |Exchange rate at time of repayment, baht/dollar | |42.00 | |
| | Total repayment in Thai baht | |2,276,400,000 | |
| | Less what Siam had EXPECTED or SCHEDULED to be repaid | |(1,355,000,000) | |
| |Amount of foreign exchange loss on debt | |921,400,000 | |
| | | | | |
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ance, Second Edition
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