Problem 10.

1 P & G India
Proctor and Gambles affiliate in India, P & G India, procures much of its toiletries product line from a Japanese company. Because of the shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. P & G India wishes to hedge a 8.5 million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen. Additionally, a common practice in India is for companies like P & G India to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy. Assumptions 180-day account payable, Japanese yen () Spot rate (/$) Spot rate, rupees/dollar (Rs/$) Implied (calculated) spot rate (/Rs) 180-day forward rate (/Rs) Expected spot rate in 180 days (/Rs) 180-day Indian rupee investing rate 180-day Japanese yen investing rate Currency agent's exchange rate fee P & G India's cost of capital Hedging Alternatives 1. Remain Uncovered, settling A/P in 180 days at spot rate If spot rate in 180 days is same as current spot If spot rate in 180 days is same as forward rate If spot rate in 180 days is expected spot rate 2. Buy Japanese yen forward 180 days Settlement amount at forward rate (Rs) 3. Money Market Hedge Principal A/P () discount factor for yen investing rate for 180 days Principal needed to meet A/P in 180 days () Current spot rate (/Rs) Indian rupee, current amount (Rs) P&G India's WACC carry-forward factor for 180 days Future value of money market hedge (Rs) 4. Indian Currency Agent Hedge Principal A/P () Current spot rate (/Rs) Current A/P (Rs) Plus agent's fee (4.850%) P & G India's WACC carry-forwad factor for 180 days on fee Total future value of agent's fee (Rs) Total A/P, future value, A/P + fee (Rs) Evaluation of Alternatives The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives. 8,500,000.00 2.5257 3,365,464.34 163,225.02 1.0600 173,018.52 3,538,482.87 Certain 8,500,000.00 0.9926 8,436,724.57 2.5257 3,340,411.26 1.0600 3,540,835.94 3,541,666.67 2.4000 Certain 3,365,464.34 3,541,666.67 3,269,230.77 2.5257 2.4000 2.6000 Risky Risky Risky Values 8,500,000 120.60 47.75 2.5257 2.4000 2.6000 8.000% 1.500% 4.850% 12.00% Values

(120.60 / 47.75)

Spot Rate (Rp/$)

Risk Assessment

Certain

Problem 10.2 Siam Cement

Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s, taking on massive quantities of foreign currency denominated debt (primarily U.S. dollars). When the Thai baht (B)was devalued from its pegged rate of B25.0/$ in July 1997, Siams interest payments alone were over $900 million on its outstanding dollar debt (with an average interest rate of 8.40% on its U.S. dollar debt at that time). Assuming Siam Cement took out $50 million in debt in June 1997 at 8.40% interest, and had to repay it in one year when the spot exchange rate had stabilized at B42.0/$, what was the foreign exchange loss incurred on the transaction? Assumptions US dollar debt taken out in June 1997 US dollar borrowing rate on debt Initial spot exchange rate, baht/dollar, June 1997 Average spot exchange rate, baht/dollar, June 1998 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 Repayment of US dollar debt: Interest Total repayment Exchange rate at time of repayment, baht/dollar Total repayment in Thai baht Total proceeds from loan, up-front, in Thai baht Net interest to be paid, in Thai baht Actual Repayment: Repayment of US dollar debt: Principal Repayment of US dollar debt: Interest Total repayment Exchange rate at time of repayment, baht/dollar Total repayment in Thai baht Less what Siam had EXPECTED or SCHEDULED to be repaid Amount of foreign exchange loss on debt Value 50,000,000 8.400% 25.00 42.00

$ $

50,000,000 4,200,000 54,200,000 25.00 1,355,000,000 1,250,000,000 105,000,000

$ $

50,000,000 4,200,000 54,200,000 42.00 2,276,400,000 (1,355,000,000) 921,400,000

Problem 10.3 BioTron Medical, Inc.

Brent Bush, CFO of a medical device manufacturer, BioTron Medical, Inc., was approached by a Japanese customer, Numata, with a proposal to pay cash (in yen) for its typical orders of 12,500,000 every other month if it were given a 4.5% discount. Numata's current terms are 30 days with no discounts. Using the following quotes and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments with forward contracts. Spot rate, /$ 30-day forward rate, /$ 90-day forward rate, /$ 180-day forward rate, /$ Numata's WACC BioTron Medical's WACC 111.40/$ 111.00/$ 110.40/$ 109.20/$ 8.850% 9.200%

How much in U.S. dollars will BioTron Medical receive 1) with the discount and 2) with no discount but fully covered with a forward contract? Assumptions BioTron's 30-day account receivable, Japanese yen Spot rate, /$ 30-day forward rate, /$ 90-day forward rate, /$ 180-day forward rate, /$ Numata's WACC BioTron Medical's WACC Desired discount on purchase price by Numata Brent Bush 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) Discount for cash payment up-front (4.500%) Amount paid in cash net of discount Current spot rate Amount received in U.S. dollars by Seattle Scientific 2. Not offer any discounts for early payment and cover exposure with forwards Account receivable (yen) 30-day forward rate Amount received in cash in dollars, in 30 days Discount factor for 30 days @ Seattle's WACC Present value of dollar cash received 12,500,000 111.00 112,612.61 0.9924 111,755.82 12,500,000 (562,500) 11,937,500 111.40 107,158.89 Values 12,500,000 111.40 111.00 110.40 109.20 8.850% 9.200% 4.500%

Brent Bush should politely decline Numata's offer to pay cash in exchange for the requested discount.

Problem 10.4 Embraer of Brazil

Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other). Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100 people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs it must pay foreign suppliers $20 million for inputs one year from now (but they will be delivering the sub-components throughout the year). The current spot rate on the Brazilian real (R$) is R$1.8240/$, but it has been steadily appreciating against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and considered expensive. Citibank Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the current 4.00% U.S. dollar eurocurrency rate and the 10.50% Brazilian government deposit note. Assumptions Receivable due in one year, US dollars Payable due in one year, US dollars Spot rate, reais per dollar (R$/$) One-year US dollar eurocurrency interest rate One-year Brazilian govt deposit note Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) Values $80,000,000 $20,000,000 1.8240 4.00% 10.50% 1.9380 Risk Assessment

Analysis Net exposure at time of cash settlements: One year A/R due One year A/P due Net exposure

Values

$80,000,000 ($20,000,000) $60,000,000

Certain

This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian reais, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a very good thing.

Cash settlement of the net position: Brazilian reais in one year at current spot rate Brazilian reais in one year at one year forward rate R$ 109,440,000.00 R$ 116,280,000.00 Risky Certain

In this case, however, because the reais is selling forward at a considerable discount, the net long position -- if sold forward -yields considerably more reais than the current spot rate. It should also be noted, however, that if the reais were to fall considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.

Problem 10.5 Vizor Pharmaceuticals

Vizor Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in this case, a cash settlement of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared unattractive, Vizor had to contact several major banks before even finding a forward quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging recommendation. Assumptions Receivable due in 3 months, in Indonesian rupiah (Rp) Spot rate (Rp/$) Expected spot rate in 90 days (Rp/$) 3-month forward rate (Rp/$) Minimum dollar amount acceptable at settlement Values Rp1,650,000,000 9,450 9,400 9,950 $168,000.00 At Spot $174,603.17

Alternatives 1. Remain Uncovered. Settle A/R in 90 days at current spot rate. If spot rate in 90 days is same as current (Rp 1,650,000,000 / Rp 9,450/$) If spot rate in 90 days is Rp9,400/$ (Rp 1,650,000,000 / Rp 9,400/$) If spot rate in 90 days is Rp9,800/$ (Rp 1,650,000,000 / Rp 9,950/$)

Values

Risk Assessment

$174,603.17

Risky

$175,531.91

Risky

$165,829.15

Risky

2. Sell Indonesian rupiah forward. A/R sold forward 90 days "Cost of cover" is the forward discount on Rp Analysis The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level. Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets. In the end, Vizor will have to decide whether making the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using a forward cover. $165,829.15 -20.1% Certain

Problem 10.6 Mattel Toys

Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, 30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattels treasury team has collected the following currency and market quotes. The companys foreign exchange advisors believe the euro will be at about $1.4200/ in 90 days. Mattels management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable. Current spot rate ($/) Credit Suisse 90-day forward rate ($/) Barclays 90-day forward rate ($/) Mattel Toys WACC ($) 90-day eurodollar interest rate 90-day euro interest rate 90-day eurodollar borrowing rate 90-day euro borrowing rate Assumptions 90-day A/R () Current spot rate ($/) Credit Suisse 90-day forward rate ($/) Barclays 90-day forward rate ($/) Expected spot rate in 90 days ($/) 90-day eurodollar interest rate 90-day euro interest rate Implied 90-day forward rate (calculated, $/) 90-day eurodollar borrowing rate 90-day euro borrowing rate Mattel Toys weighted average cost of capital ($) $1.4158 $1.4172 $1.4195 9.600% 4.000% 3.885% 5.000% 5.000% Values 30,000,000.00 $1.4158 $1.4172 $1.4195 $1.4200 4.000% 3.885% $1.4162 5.000% 5.000% 9.600% Risk Assessment

Hedging Alternatives 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 If spot rate in 90 days is same as Credit Suisse forward rate If spot rate in 90 days is same as Barclays forward rate If spot rate in 90 days is expected spot rate 2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate Settlement amount at Barclays forward rate 3. Money Market Hedge Principal A/R in euros discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R Current spot rate, $/euro US dollar current value Mattel's WACC carry-forward factor for 90 days Future value of money market hedge Evaluation of Alternatives

Values

$42,474,000.00 $42,516,000.00 $42,585,000.00 $42,600,000.00

Risky Risky Risky Risky

$42,516,000.00 $42,585,000.00

Certain Certain

30,000,000.00 0.9877 29,629,629.63 $1.4158 $41,949,629.63 1.0240 $42,956,420.74

1/(1 + (.05 x 90/360))

1 + (.0960 x 90/360) Certain

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).

111

Problem 10.7 Bobcat Company

Bobcat Company, U.S.-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won7,500 million. Won1,000 million has already been paid, and the remaining Won6,500 million is due in six months. The current spot rate is Won1,110/$, and the 6-month forward rate is Won1,175/$. The sixmonth Korean won interest rate is 16% per annum, the six-month US dollar rate is 4% per annum. Bobcat can invest at these interest rates, or borrow at 2% per annum above those rates. A six-month call option on won with a 1200/$ strike rate has a 3.0% premium, while the six-month put option at the same strike rate has a 2.4% premium.

Bobcat can invest at the rates given above, or borrow at 2% per annum above those rates. Bobcat's weighted average cost of capital is 10%. Compare alternate ways that Bobcat might deal with its foreign exchange exposure. What do you recommend and why? Assumptions Purchase price of Korean manufacturer, in Korean won Less initial payment, in Korean won Net settlement needed, in Korean won, in six months Current spot rate (Won/$) Six month forward rate (Won/$) Bobcat's cost of capital (WACC) Options on Korean won: Strike price, won Option premium (percent) Values 7,500,000,000 (1,000,000,000) 6,500,000,000 1,110 1,175 10.00% Call Option 1,200.00 3.000% United States 4.000% 2.000% 6.000% Values Put Option 1,200.00 2.400% Korea 16.000% 2.000% 18.000% Certainty

Six-month investment (not borrowing) interest rate (per annum) Borrowing premium of 2.000% Six-month borrowing rate (per annum) Risk Management Alternatives 1. Remain uncovered, making the won payment in 6 months at the spot rate in effect at that date Account payable (won) Possible spot rate in six months: current spot rate (won/$) Cost of settlement in six months (US$) Account payable (won) Possible spot rate in six months: forward rate (won/$) Cost of settlement in six months (US$) 2. Forward market hedge. Buy won forward six months Account payable (won) Forward rate (won/$) Cost of settlement in six months (US$)

6,500,000,000 1,110 5,855,855.86 6,500,000,000 1,175 5,531,914.89

Uncertain.

Uncertain.

6,500,000,000 1,175.00 5,531,914.89

Certain.

3. Money market hedge. Exchange dollars for won now, invest for six months. Account payable (won) Discount factor at the won interest rate for 6 months Won needed now (payable/discount factor) Current spot rate (won/$) US dollars needed now Carry forward rate for six months (WACC) US dollar cost, in six months, of settlement 4. Call option hedge. (Need to buy won = call on won) Option principal Current spot rate (won/$) Premium cost of option (%) Option premium (principal/spot rate x % pm) If option exercised/not exercised, dollar cost of won Premium carried forward six months (pm x 1.125, WACC) Total net cost of call option hedge if exercised If exercised 6,500,000,000 1,110.00 3.000% 175,675.68 5,416,666.67 184,459.459 5,601,126.13 Maximum. $ $ If not exercised 1,300.00 6,500,000,000 1.080 6,018,518,518.52 1,110.00 5,422,088.76 1.050 5,693,193.19

$ $

Certain.

$ $ $

5,000,000.00 184,459.46 5,184,459.46

The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be a weaker Won, Won1,200/$ or higher, then the call option would be a lower cost alternative. This would require, however, that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the Won did not fall to the needed level.

Problem 10.8 Aquatech

Aquatech is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 11th the company sold a system to the City of Nagasaki, Japan, for installation in Nagasakis famous Glover Gardens (where Puccinis Madame Butterfly waited for the return of Lt. Pinkerton.) The sale was priced in yen at 20,000,000, with payment due in three months. Spot exchange rate: One-month forward rate: Three-month forward: One-year forward: Money Rates One month Three months Twelve months United States 4.8750% 4.9375% 5.1875% 118.255/$ (closing mid-rates) 117.760/$, a 5.04% p.a. premium 116.830/$, a 4.88% p.a. premium 112.450/$, a 5.16% p.a. premium Japan 0.09375% 0.09375% 0.31250% Differential 4.78125% 4.84375% 4.87500%

Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot 118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from 118.30/$ to 117.550/$. Additional information: Aquatechs Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese money rate. Aquatech's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable. Three-month options from Kyushu Bank: * Call option on 20,000,000 at exercise price of 118.00/$: a 1% premium. * Put option on 20,000,000, at exercise price of 118.00/$: a 3% premium. a) What are the costs and benefits of alternative hedges? Which would you recommend, and why? b) What is the break-even reinvestment rate when comparing forward and money market alternatives? Assumptions Amount of receivable, Japanese yen () Spot exchange rate at time of sale (/$) Booked value of sale (amount/spot rate) Days receivable due Aquatech's WACC Competitor borrowing premium, yen () Forward rates and premiums One-month forward rate (/$) Three-month forward rate (/$) One-year forward rate (/$) Investment rates, % per annum 1 month 3 months 12 months Purchased options 3-month call option on yen 3-month put option on yen a. Alternative Hedges 1. Remain uncovered. Account receivable (yen) Possible spot rate in 90 days (yen/$) Cash settlement in 90 days (US$) 2. Forward market hedge. Account receivable (yen) Forward rate (won/$) Cash settlement in 90 days (US$) 3. Money market hedge. Account receivable (yen) Discount factor for 90 days Yen proceeds up front Current spot rate (won/$) US dollars received now Carry forward at Aquatech's WACC Proceeds in 90 days 4. Put option hedge. (Need to sell yen = put on yen) Option principal Current spot rate (won/$) Premium cost of option (%) Option pm (principal/spot rate x % pm) If option exercised, dollar proceeds Less Pm carried forward 90 days Net proceeds in 90 days 20,000,000 1.00523 19,895,858 118.255 $168,245.38 1.0400 $174,975.20 1 + ((.0009375 + .02) x 90/360) 20,000,000 116.830 $171,188.91 20,000,000 118.255 $169,126.04 Values 20,000,000 118.255 $169,126.04 90 16.0% 2.0% Forward Rate 117.760 116.830 112.450 United States 4.8750% 4.9375% 5.1875% Strike (yen/$) 118.000 118.000 Values Premium 5.04% 4.88% 5.16% Japan 0.09375% 0.09375% 0.31250% Premium 1.0% 3.0% Certainty

Uncertain.

Certain.

1 + (.16 x 90/360) Certain.

20,000,000 118.255 3.000% $5,073.78 $169,491.53 (5,276.732) $164,214.79

1.04 carry-forward rate Minimum.

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% $168,245.38 (1+x) = $171,188.91 x 1.74954% For 90 days Breakeven rate, % per annum $0.06998

Problem 10.9 Compass Rose

Compass Rose, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory forward contract cover formula: Compass Rose's Manadatory Forward Cover Paying the points forward Receiving the points forward 0-90 days 75% 100% 91-180 days 60% 90% > 180 days 50% 50%

Compass Rose expects to receive multiple payments in Danish kroner over the next year. DKr 3,000,000 is due in 90 days; DKr 2,000,000 is due in 180 days; and DKr 1,000,000 is due in one year. Using the following spot and forward exchange rates, what would be the amount of forward cover required by company policy by period? Forward Discount -0.85% -0.85% -0.84% 91-180 days 2,000,000 1,000,000 > 180 days

Assumptions Spot rate, DKr/C$ 3-month forward rate, DKr/C$ 6-month forward rate, DKr/C$ 12-month forward rate, DKr/C$ South Face's Exposures A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr

Values 4.70 4.71 4.72 4.74 0-90 days 3,000,000

Analysis & Exposure Management The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward. Compass Rose is receiving foreign currency, DKr, at future dates ("long DKr"). Compass Rose is therefore expecting to PAY THE POINTS FORWARD. Required Forward Cover for Compass Rose: A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr DKr Forward Cover A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr Expected Canadian dollar value of DKr sold forward 0-90 days 75% 91-180 days 60% 50% > 180 days

2,250,000 1,200,000 477,707.01 254,237.29 500,000 105,485.23

Problem 10.10 Pupule Travel

Pupule Travel, a Honolulu, Hawaii based 100% privately owned travel company has signed an agreement to acquire a 50% ownership share of Taichung Travel, a Taiwan based privately owned travel agency specializing in servicing inbound customers from the United States and Canada. The acquisition price is 7 million Taiwan dollars (T$ 7,000,000) payable in cash in 3 months. Thomas Carson, Pupule Travels owner, believes the Taiwan dollar will either remain stable or decline a little over the next 3 months. At the present spot rate of T$35/$, the amount of cash required is only $200,000 but even this relatively modest amount will need to be borrowed personally by Thomas Carson. Taiwanese interest-bearing deposits by non-residents are regulated by the government, and are currently set at 1.5% per year. He has a credit line with Bank of Hawaii for $200,000 with a current borrowing interest rate of 8% per year. He does not believe that he can calculate a credible weighted average cost of capital since he has no stock outstanding and his competitors are all also privately-owned without disclosure of their financial results. Since the acquisition would use up all his available credit, he wonders if he should hedge this transaction exposure. He has quotes from Bank of Hawaii shown in the table below.

Spot rate (T$/$) 3-month forward rate (T$/$) 3-month Taiwan dollar deposit rate 3-month dollar borrowing rate 3-month call option on T$

33.40 32.40 1.500% 6.500% not available

Analyze the costs and risks of each alternative, and then make a recommendation as to which alternative Thomas Carson should choose. Assumptions Acquisition price & 3-month A/P, NewTaiwan dollars (T$) Spot rate (T$/$) 3-month forward rate (T$/$) 3-month Taiwan dollar deposit rate 3-month dollar borrowing rate 3-month call option on T$ Thomas Carson's credit line with Bank of Hawaii Evaluation of Alternatives 1. Do Nothing -- Wait 3 months and buy T$ spot If spot rate is the same as current spot rate If spot rate is the same as 3-month forward rate 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 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 Discounted back 3-months at T$ deposit rate Amount of NT$ needed now for deposit Spot rate, T$/$ US$ needed now for exchange US$ carry-forward rate (3-month dollar borrowing rate) Carry-forward factor of US$ for 3-month period Total cost in US$ of settling A/P in 3-months with Money Market Hedge 7,000,000 0.9963 6,973,848 33.40 208,797.85 6.500% 1.0163 212,190.81 Certain $ 216,049.38 Certain $ $ 209,580.84 216,049.38 Risky Risky Values 7,000,000 33.40 32.40 1.500% 6.500% not available 200,000 Cost Certainty

The currency risk is eliminated, but since Thomas Carson would have to exchange the money up front, it would require him to borrow the money, increasing his debt outstanding for the entire 3 months. Discussion. This is a difficult decision. The forward contract appears to be the preferable choice, protecting him against an appreciating T$, and creating a certain cash purchase payment. The problem, however, will be whether the Bank of Hawaii will allow him to purchase a forward for the full $216,049.38, which is slightly above his credit line currently in place. If his relationship is good with the bank, they most likely would increase his line sufficiently to allow the forward contract.

Problem 10.11 Chronos Time Pieces

Chronos Time Pieces of Boston exports wrist watches to many countries, selling in local currencies to watch stores and distributors. Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the forward market, but occasionally with options. Chronos's foreign exchange policy is such that the 70% hedge may be increased up to a 120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has issued a 90-day invoice to its buyer for 1,560,000. The current spot rate is $1.2224/, the 90-day forward rate is $1.2270/. Chronoss treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently believes the euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16/. Assumptions Account recievable in 90 days () Initial spot exchange rate ($/) Forward rate, 90 days ($/) Expected spot rate in 90 to 120 days ($/): Case #1 Expected spot rate in 90 to 120 days ($/): Case #2 Values 1,560,000 $1.2224 $1.2270 $1.1600 $1.2600 Hedged the Minimum 70% 1,560,000 70% 1,092,000 $1.2270 $1,339,884 Hedged the Maximum 120% 1,560,000 120% 1,872,000 $1.2270 $2,296,944

If Chronos Time Pieces Proportion of exposure to be hedged Total exposure () hedged proportion Minimum hedge in euros (exposure x min prop) at the forward rate ($/) locking in ($) Case #1: Ending spot rate Proportion uncovered (short) If ending spot rate is ($/) Value of uncovered proportion ($) Value of covered proportion (from above) Total net proceeds, covered + uncovered Case #2: Ending spot rate Proportion uncovered (short) If ending spot rate is ($/) value of uncovered proportion ($) Value of covered position (from above) Total net proceeds, covered + uncovered Benchmark: Full (100%) forward cover $

468,000 $1.1600 $542,880 $1,339,884 $1,882,764

( 312,000) $1.1600 ($361,920) $2,296,944 $1,935,024

468,000 $1.2600 $589,680 1,339,884 $1,929,564 $1,914,120 $

( 312,000) $1.2600 ($393,120) 2,296,944 $1,903,824 $1,914,120

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.

Problem 10.12 Lucky 13

Lucky 13 Jeans of San Antonio, Texas, is completing a new assembly plant near Guatemala City. A final construction payment of Q8,400,000 is due in six months. (Q is the symbol for Guatemalan quetzals.) Lucky 13 uses 20% per annum as its weighted average cost of capital. Todays foreign exchange and interest rate quotations are as follows: Construction payment due in six-months (A/P, quetzals) Present spot rate (quetzals/$) Six-month forward rate (quetzals/$) Guatemalan six-month interest rate (per annum) U.S. dollar six-month interest rate (per annum) Lucky 13's weighted average cost of capital (WACC) 8,400,000 7.0000 7.1000 14.000% 6.000% 20.000%

Lucky 13's treasury manager, concerned about the Guatemalan economy, wonders if Lucky 13 should be hedging its foreign exchange risk. The managers own forecast is as follows: Expected spot rate in six-months (quetzals/$): Highest expected rate (reflecting a significant devaluation) Expected rate Lowest expected rate (reflecting a strengthening of the quetzal)

8.0000 7.3000 6.4000

What realistic alternatives are available to Lucky 13 for making payments? Which method would you select and why? What realistic alternatives are available to Lucky 13? 1. Wait six months and make payment at spot rate Highest expected rate Expected rate Lowest expected rate 2. Purchase quetzals forward six-months (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) Cost in dollars today (quetzals to $ at spot rate) factor to carry dollars forward 180 days (1 + (WACC/2)) Cost in dollars in six-months ($ carried forward 180 days ) $ $ $ $ 1,050,000.00 1,150,684.93 1,312,500.00 1,183,098.59 Risky Risky Risky Certain Cost Certainty

$ $

7,850,467.29 1,121,495.33 1.10 1,233,644.86

Certain

The second choice, the forward contract, results in the lowest cost alternative among certain alternatives.

Problem 10.13 Burton Manufacturing

Jason Stedman is the director of finance for Burton Manufacturing, a U.S.-based manufacturer of hand-held computer systems for inventory management. Burtons system combines a low-cost active bar-code used on inventory (the bar-code tags emit an extremely low-grade radio frequency) with custom-designed hardware and software which tracks the low-grade emissions for inventory control. Burton has completed the sale of a bar-code system to a British firm, Pegg Metropolitan (UK), for a total payment of 1,000,000. The following exchange rates were available to Burton on the following dates corresponding to the events of this specific export sale. Assume each month is 30 days. Spot Rate ($/) 1.7850 1.7465 1,000,000 1.7689 1.7840 1.7290 Forward Rate ($/) 1.7771 1.7381 1.7602 1.7811 --------Days Forward of Forward Rate 210 180 90 30 ---------

Date February 1 March 1 June 1 August 1 September 1 Analysis

Event Price quotation for Pegg Contract signed for sale Contract amount, pounds Product shipped to Pegg Product received by Pegg Grand Met makes payment

a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Pegg Metropolitan, and the shipment 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). Value as settled Value as booked FX gain (loss) 1 million pounds @ $1.7290/pound 1 million pounds @ $1.7689/pound $1,729,000 $1,768,900 ($39,900)

b. The value of the foreign exchange gain (loss) will depend upon when Jason actually purchases the forward contract. Because 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. Forward contract purchased on June 1 Value of forward settlement 1 million pounds @ $1.7602/pound Value as booked 1 million pounds @ $1.7689/pound FX gain (loss)

$1,760,200 $1,768,900 ($8,700)

A more aggressive alternative is for Jason to purchase the forward contract on the date that the contract was signed, March 1, lockingin Burton's U.S. dollar settlement amount a full 90 days earlier in the transaction exposure's life span. Forward contract purchased on March 1 Value of forward settlement 1 million pounds @ $1.7381/pound Value as booked 1 million pounds @ $1.7689/pound FX gain (loss)

$1,738,100 $1,768,900 ($30,800)

Note that in this case if Jason had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would 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 10.14 Micca Metals, Inc.

Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific precious metals and materials which are used in a variety of pigment applications in many other industries including cosmetics, appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from Morocco for 6,000,000, dirhams, payable in six months. Miccas cost of capital is 8.600%. Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available from Bank AlMaghrub at a premium of 2%. Six-month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available at a premium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transaction exposure. What is your recommendation? Assumptions Shipment of phosphates from Morocco, Moroccan dirhams Micca's cost of capital (WACC) Spot exchange rate, dirhams/$ Six-month forward rate, dirhams/$ Options on Moroccan dirhams: Strike price, dirhams/$ Option premium (percent) Values 6,000,000 14.000% 10.00 10.40 Call Option 10.00 2.000% United States 6.000% 5.000% Values Put Option 10.00 3.000% Morocco 8.000% 7.000% Certainty

Six-month interest rate for borrowing (per annum) Six-month interest rate for investing (per annum) Risk Management Alternatives 1. Remain uncovered, making the dirham payment in six months at the spot rate in effect at that date Account payable (dirhams) Possible spot rate in six months -- the current spot rate (dirhams/$) Cost of settlement in six months (US$) Account payable (dirhams) Possible spot rate in six months -- forward rate (dirhams/$) Cost of settlement in six months (US$) 2. Forward market hedge. Buy dirhams forward six months. Account payable (dirhams) Six month forward rate, dirhams/$ Cost of settlement in six months (US$)

6,000,000 10.00 600,000.00 6,000,000 10.40 576,923.08

Uncertain.

Uncertain.

6,000,000 10.40 576,923.08

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 4. Call option hedge. (Need to buy dirhams = call on dirhams) Option principal Current spot rate, dirhams/$ Premium cost of option Option premium (principal/spot rate x % pm) If option exercised, dollar cost at strike price of 10.00 dirhams/$ Plus premium carried forward six months (pm x 1.07, WACC) Total net cost of call option hedge if exercised

Certain.

$ $ $

6,000,000.00 10.00 2.000% 12,000.00 600,000.00 12,840.000 612,840.00

Maximum.

The lowest cost certain alternative is the forward. If Micca were to expect the dirham to depreciate significantly over the next six months, it may choose the call option.

Problem 10.15 Maria Gonzalez and Trident

Trident the same U.S.-based company discussed in this chapter, has concluded a second larger sale of telecommunications equipment to Regency (U.K.). Total payment of 3,000,000 is due in 90 days. Maria Gonzalez has also learned that Trident will only be able to borrow in the United Kingdom at 14% per annum (due to credit concerns of the British banks). Given the following exchange rates and interest rates, what transaction exposure hedge is now in Tridents best interest? Assumptions 90-day A/R in pounds Spot rate, US$ per pound ($/) 90-day forward rate, US$ per pound ($/ ) 3-month U.S. dollar investment rate 3-month U.S. dollar borrowing rate 3-month UK investment interest rate 3-month UK borrowing interest rate Put options on the British pound: Strike rates, US$/pound ($/ ) Strike rate ($/) Put option premium Strike rate ($/) Put option premium Trident's WACC Maria Gonzalez's expected spot rate in 90 days, US$ per pound ($/ ) Alternative #1: Remain Uncovered Value of A/R will be (3 million pounds x ending spot rate ($/pound)) If spot rate is the same as current spot rate If ending spot rate is the same as current forward rate If ending spot rate is the expected spot rate Alternative #2: Forward Contract Hedge Sell the pounds forward 3 months, locking in the forward rate Pound A/R at the forward rate (pounds x forward) Alternative #3: Money Market Hedge Borrows against the A/R, receiving up-front, exchanging into US$. Amount of A/R in 90-days, in pounds Discount factor, pound borrowing rate, for 3-months Proceeds of borrowing, up-front, in pounds Exchanged to US$ at current spot rate of US$ received against A/R, up-front US$ need to be carried forward for comparison: Carry-forward rate, WACC for 90 days Money Market Hedge, US$, at end of 90 days Value 3,000,000.00 $1.7620 $1.7550 6.000% 8.000% 8.000% 14.000% $1.75 1.500% $1.71 1.000% 12.000% $1.7850 Rate ($/pound) $1.7620 $1.7550 $1.7850 Rate ($/pound) $1.7550 Rate ($/pound) Proceeds $5,286,000.00 $5,265,000.00 $5,355,000.00 Proceeds $5,265,000.00 Proceeds 3,000,000.00 0.9662 2,898,550.72 $1.7620 $5,107,246.38 1.0300 $5,260,463.77 Strike Rate ($/pnd) 1.75 1.500% 3,000,000.00 $1.7620 $79,290.00 1.0300 $81,668.70 $5,250,000.00 (81,668.70) $5,168,331.30 $1.7825 $5,347,500.00 (81,668.70) $5,265,831.30 Strike Rate ($/pnd) 1.71 1.000% 3,000,000.00 $1.7620 $52,860.00 1.0300 $54,445.80 $5,130,000.00 (54,445.80) $5,075,554.20 $1.7732 $5,319,600.00 (54,445.80) $5,265,154.20

Alternative #4: Put Option Hedges Option premium Notional principal of option (pounds) Spot rate ($/pound) Option premium, US$ Carry-forward factor, WACC, for 90 days Total premium cost, in 90 days Proceeds from put option if exercised Less cost of premium, including time-value Net proceeds from put options, in 90 days: Minimum Ending spot rate needed to be superior to forward: Proceeds from exchanging pounds for US$ spot Less cost of option (allowed to expire OTM) Net proceeds from put option, unexercised

Analysis: Maria Gonzalez would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is less attractive as a result of the higher borrowing costs in the U.K. now. The two put options would 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 were $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.

Problem 10.16 Larkin Hydraulics

On May 1st, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to RebeckeTerwilleger Company of the Netherlands for 4,000,000, payable 2,000,000 on August 1st and 2,000,000 on November 1st. Larkin derived its price quote of 4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/.

By the time the order was received and booked on May 1st, the euro had strengthened to $1.1000/, so the sale was in fact worth 4,000,000 x $1.1000/ = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless Larkin's director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible:

1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/ and the 6-month forward quote was $1.1130/. 2. Hedge in the money market. Larkin could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum. 3. Hedge with foreign currency options. August put options were available at a strike price of $1.1000/ for a premium of 2.0% per contract, and November put options were available at $1.1000/ for a premium of 1.2%. August call options at $1.1000/ could be purchased for a premium of 3.0%, and November call options at $1.1000/ were available at a 2.6% premium. 4. Do nothing. Larkin could wait until the sales proceeds were received in August and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market. Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long-term debt. U.S. T-bills yield 3.6% per annum. What should Larkin do? Assumptions 90-day Forward rate, $/ 180-day Forward rate, $/ US Treasury bill rate Larkin's borrowing rate, euros, per annum Larkin's cost of equity Options on euros August maturity options November maturity options Valuation of Alternative Hedges Amount of receivable, in euros a. Hedge in the forward market Amount of receivable, in euros Respective forward rates ($/) US dollar proceeds as hedged ($) Carry forward to Nov 1st at WACC Total US$ proceeds on Nov 1st Total of both payments b. Hedge in the money market Amount of receivable, in euros Discount factor for euro funds, period Current proceeds from discounting, euros Current spot rate ($/) Current US dollar proceeds Carry forward rate for the period US dollar proceeds on future date Total of both payments c. Hedge with options Amount of receivable, in euros Buy put options for maturities (% x spot value) Carry forward for the period Premium cost carried forward to Nov 1 Gross put option value if exercised Carried forward 3 months to Nov 1 Gross proceeds, Nov 1 Total net proceeds, after premium deduction, Nov 1 d. Do nothing (remain uncovered) Amount of receivable, in euros Ending spot exchange rate ($/) 2,000,000 ??? 2,000,000 ??? 2,000,000 ($44,000) 1.06 ($46,640) $2,200,000 1.03 $2,266,000 $4,391,376 2,000,000 ($26,400) 1.06 ($27,984) $2,200,000 ---$2,200,000 2,000,000 1.02 1,960,784 $1.1000 $2,156,863 1.06 $2,286,275 $4,528,582 2,000,000 1.04 1,923,077 $1.1000 $2,115,385 1.06 $2,242,308 2,000,000 $1.1060 $2,212,000 1.03 $2,278,360 $4,504,360 2,000,000 $1.1130 $2,226,000 ----$2,226,000 Values $1.1060 $1.1130 3.600% 8.000% 12.000% Strike ($/euro) $1.1000 $1.1000 Today is May 1 Date April 1 May 1 Exchange Rate ($/) $1.0800 $1.1000

Call Option 3.0% 2.6% August Receivable 2,000,000

Put Option 2.0% 1.2% November Receivable 2,000,000

The money market hedge provides the highest certain outcome. If Larkin Hydraulics 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.

Mini-Case: Banbury Impex (India)

Lapura's Turkish sale is for TL 369,825 ($250,000 at the current spot rate of TL1.4793/$). The receivable is for settlement 60 days from now (end of January, it is currently the end of November). Since Lapura has no real insight -- or view -- on the direction of exchange rate movements, there is no motivation to use currency options. Options require a directional view by the user if they are to be considered preferable to forward contracts. Assumptions Indian rupees per US dollar Indian rupees per euro Japanese yen per rupee Indian rupees per Turkish lira Turkish lira per US dollar US dollars per euro (calculated) Turkish lira per euro (calculated) Currency of Invoice Evaluation of Alternatives Original receivable Spot rate (Turkish lira per currency) Redenominated receivable (60 days) Forward rate (INR/currency) Indian rupee proceeds in 60 days Spot 45.8300 60.9611 1.8250 30.7192 1.4793 1.3302 1.9677 Turkish lira Exposure 369,825 TL ----369,825 TL 30.9500 INR 11,446,084 60-Day Forward 46.7000 61.9000 1.8100 30.9500 1.4800 1.3255 1.9617 US dollar Exposure 369,825 TL 1.4793 $250,000 46.7000 INR 11,675,000 Euro Exposure 369,825 TL 1.9677 187,948 61.9000 INR 11,633,964

Choosing the currency of invoice is a question of which hedge, if any, Lapura uses. If the 60-day forward rates are applied to the three different currency of invoice choices, the greatest INR proceeds result from using a dollar currency of invoice and covering the exposure with a 60-day forward rate to sell dollars for rupees. Although Lapura could leave the receivable uncovered, given the volatility of exchange rate markets, and how "cheap" forwards are at this time (meaning they differ little from the current spot rate as a result of such low interest rates in the dollar, euro, and yen markets), it would mean taking on unneeded risk. A money market hedge would be extremely difficult to accomplish in the immediate time frame. The need for a bank relationship, the establishment of a line of credit in order to secure a loan, and the unattractive interest rates (the Turkish lira borrowing rate would cut severely into the value of the receivable), all make the money market hedge impractical for this sale.