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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
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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
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Ô
! !
!
!
"
@
#!
"
"!
"" !
@
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% &' ( )
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
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% &' ( )
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
| *
% &' ( )
| +
!
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
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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 $6¼^ then Trident will receive
$1^2 ^
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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
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5
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!
$
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
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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$
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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
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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
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&
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
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;00
Derivatives drive their values from the underlying asset
They might be used for two distinct management objectives:
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± 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 VVa
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
Va
V a
V
aV ± ³American terms´
are used; quotes are in US dollar cost per unit of
foreign currency^ also known as direct quotes
| +
Contract Specifications
a
aV ± 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
llaV
alaVa 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
|VlVV ± 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
Va 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
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<
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
, .| /=> ? .|> /
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<
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 $11Ps 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
Vl 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
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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
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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
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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
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"
"
@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
aV (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
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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
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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)
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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^^12 = £^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 VVVV
V
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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
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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 VVa !VV ÷aV "
Val V#
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A breakeven investment rate can be calculated
between forward and money market hedge
)a
VV( ) +
aV(=)
a
VV(
$% %* ) +
(=$%&'
=
137
@-22-+7*
123
12+
12$
@-2*$-777
12
127
1+3
1+3 127 12 12$ 12+ 123 137 13 13$ 13+
| 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 $122£
± ote that the following graph shows the net proceeds of
the option contract under varying exchange rates et
proceeds are not same of a put option payoff diagram
because we have exposure to the underlying asset (£)
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¦ /|
V¦
V 0 /$ %&-.
| $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
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- $ -
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- $ -
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1 1 1 1 1 1 1 $ 1 1 1 1 1 1 1 1 1 1 $ 1 1 1 1 1 1
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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
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mV
|
aV
/ V-¦a
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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
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5
( "
Va
a
a
VV
V ± Trident could
aV a forward contract locking in the $1£
rate ensuring that their obligation will not be more
than $1^^
VaVa
VV
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
( "
aVa
VV
V ±
To ensure that exactly £1^^ will be received in
months^ discount the principal by pa
.
.+ # *
1 +
#*
| $2
5
( "
aVa
VV
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 $1^ 1^212
6
| $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
( "
aV
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 allV
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$1) | *
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1 1 1 1 1 1 1 1 * 1 1 1 1 1 1 1 1 1 1 * 1 1 1 1 1
| *
(
%C D
The treasury function of most firms is usual considered a cost center;
it is not expected to add to the bottom line
owever^ in practice some firms¶ treasuries have become aggressive
in currency management and act as profit centers
% D
Transaction exposures exist before they are actually booked yet
some firms do not hedge this backlog exposure
owever^ some firms are selectively hedging these backlog
exposures and anticipated exposures
%
& D
Transaction exposure management programs are generally divided
along an ³option-line;´ those which use options and those that do not
Also the amount of risk covered may vary Tare are
al
V
policies that state which proportion and type of exposure is
to be hedged by the treasury
| *$
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
| **