FINS3616 International Business Finance - Week 4

A. Conceptual questions

1. What is a forward exchange rate?

It is the agreed exchange rate today for trading one currency for another between 2
parties for a specified future date.

2. If the yen is selling at a premium relative to the euro in the forward market, is the forward
price of EUR per JPY larger or smaller than the spot price of EUR per JPY?

When JPY is expected to be at a premium, then more EUR needed to buy JPY in the
future. Thus, forward EUR/JPY is higher than spot EUR/JPY, which is the current rate.

3. If you are a U.S. firm and owe someone 10,000,000 in 180 days, what is your transaction
exchange risk?

Transaction exchange risk is the financial risk due to the changes in currency exchange
rates before settlement. In this scenario, this US firm has foreign debt in JPY due in 180
days. However, the USD/JPY exchange rate can increase significantly, meaning that it will
require more USD than to pay for the principal and to repay the interest.

4. If the spot exchange rate of the yen relative to the dollar is 105.75, and the 90-day forward
rate is 103.25/$1, is the dollar at a forward premium or discount? Express the premium or
discount as a percentage per annum for a 360-day year?

Currently, spot rate: $1 = 105.75, forward rate: $1 = 103.25, the dollar is at a forward
discount, as future exchange rate is expected to fall.

103.25 105.75 360

= 9.46%
105.75 90
5. Intel is scheduled to receive a payment of 100,000,000 in 90 days from Sony in connection
with a shipment of computer chips that Sony is purchasing from Intel. Suppose that the
current exchange rate is 103/$, that analysts are forecasting that the dollar will weaken by
1% over the next 90 days.

(1) Provide a qualitative description of Intels transaction exchange risk.

The transaction exchange risk is that Intel is due to receive payment in JPY from Sony
in a foreign currency being susceptible to exchange rate fluctuations. If forecasts are
correct about USD weakening by 1% over next 90 days, then, there would be a gain in
value of payments received. However, if the forecasts are wrong and the exchange rate
falls, then the 1bil would be worse less USD than intial costs of the propducts.

(2) If Intel chooses not to hedge its transaction exchange risk, what is Intels expected
dollar revenue?

100,000,000 is currently worth $970873.79

$
[(t,t+90) ] = 0.99 103/$ = 101.97/$

100,000,000 is expected to be worth $980680.59 in the future

6. A firm based in the United Kingdom has promised to pay bondholders 10,000 in one year.
The firm will be worth either 9,000 or 19,000 with equal probability at that time
depending on the value of the dollar. The firm will be worth 14,000 if it hedges against
currency risk.

a.Identify the values of debt and equity under unhedged and hedged scenarios assuming
there are no costs of financial distress.

Unhedged: E[Firm Value] = E[Debt] +E[Equity]

Good: 10000 (Vdebt) + 9000 (Vequity) = 19000 (Vfirm)

Bad: 9000 (Vdebt) + 0 (Vequity) = 9000 (Vfirm)

Expected: [0.5*10000+0.5*9000] + [0.5*9000+0.5*0] = 9500+4500 = 14000

Hedged: 10000 (Vdebt) + 0 (Vequity) = 14000 (hedged Vfirm)

Hedged and unhedged have same value, but hedged has less risk/volatility.
b.Suppose the firm will incur direct bankruptcy costs of 1,000 in bankruptcy. Identify the
value of debt and of equity under both unhedged and hedged scenarios.

Unhedged: E[Firm Value] = E[Debt] +E[Equity]

Good: 10000 (Vdebt) + 9000 (Vequity) = 19000 (Vfirm)

Bad: (9000-1000) (Vdebt) + 0 (Vequity) = 8000 (Vfirm) bankruptcy costs occur when firm
is unable to repay full loan amount

- But who is the bankruptcy cost paid to?

Expected: (0.5*(10000)+0.5*(9000-1000)+(0.5*9000+0.5*0) = 9000 + 4500 = 13500

Hedging: 10000 (Vdebt) + 0 (Vequity) = 14000 (hedged Vfirm)

Hedging in this case is beneficial as it guarantees the firm value to be 14000.

c.In addition to the 1,000 direct bankruptcy cost, suppose indirect costs reduce the asset
value of the firm to either 6,000 or 18,000 (before the 1,000 direct bankruptcy cost)
with equal probability. Hedging results in firm value of 12,000 with certainty. Identify
the value of debt and of equity under both unhedged and hedged scenarios.

Using new possible values

Unhedged: E[Firm Value] = E[Debt] +E[Equity]

Good: 10000 (Vdebt) + 8000 (Vequity) = 18000 (Vfirm)

Bad: (6000-1000) (Vdebt) + 0 (Vequity) = 5000 (Vfirm) bankruptcy costs occur when firm
is unable to repay full loan amount

Expected: (0.5*(6000-1000)+0.5*10000)+(0.5*0+0.5*9000) = 7500 + 4000=11500

Hedging: 10000 (Vdebt) + 2000 (Vequity) = 12000 (hedged Vfirm)

Hedging in this case is beneficial as it guarantees the firm value to be 12000.

d.Can hedging add value to shareholders in this problem?

Hedging does not add value to shareholders. It benefits bondholders and overall firm value
at the expenses of shareholders. To add value to shareholders, they should negotiate for
lower interest payments on debt.
B. True or False questions

1. A major problem with a currency forward contract is that one party always has an incentive
to default when the actual spot rate diverges from the contract price.

False there are financial obligations to honour the contract by both parties
True it is difficult to trade with a third-party to offset position.
This is as opposed to Futures, which involves a clearinghouse that guarantees payment,
delivery and nullifies any default risk. Futures are widely tradeable.

2. If the closing spot rate is $0.5800/C$ at the expiration of a forward contract, a party that has
sold dollars at a forward rate of $0.5754/C$ has an incentive to default.

False Contract: 1 USD for 1.7379, Market Value: 1 USD for 1.7241. The party has no
incentive to default as it is receiving more CAD that market value. It would make a profit of
0.008 USD if it decided to exchange CAD back to USD.

3. In a forward contract, an exchange clearinghouse takes one side of every transaction.

False no exchange clearinghouse in forward contracts. They are issued by commercial banks

4. The majority of forward contracts are settled at maturity.

True

5. In perfect financial markets, corporate hedging policy has no value.

True - ? does it not have value as all firms are competitively hedging

6. If financial markets are informationally efficient, then corporate financial policy is irrelevant.
True

7. In the real world, corporate hedging policy can change expected future cash flows but is
unlikely to reduce the cost of debt.
False hedging decreases the variability of firm value thus reduce the risk of debt and thus
would the required return charged by debtholders, hence reduce cost of debt.

8. One important purpose of the forward markets for foreign exchange allows global traders to
protect themselves by speculating
True
C. MCQ

1. What is the name of the exchange rate specified in the forward contract?
a. spot rate
b. forward rate
c. future exchange rate
d. cross-rate
e. none of the above

2. If you want to hedge the risk from paying a firm foreign currency in the future, you would
a. buy the foreign currency forward.
b. sell the foreign currency forward.
c. speculate on the possibility to not hedge.
d. buy the currency now and deposit into a bank account until needed.
e. do nothing

3. If the forward price of a currency contract is higher than the spot rate, the currency is said to be at a
a. forward discount.
b. forward premium.
c. future expected exchange rate.
d. forward swap rate.
e. none of the above

4. If the euro is selling at a premium relative to the USD in the forward market, is the forward price of
USD /EUR larger or smaller than the spot price of the USD /EUR?
a. larger
b. smaller
c. indeterminate
d. the same
e. none of the above

5. Why are the bid-ask spreads larger in the forward market than in the spot market?
a. because the forward market is less liquid than the spot market
b. because the spot market is more volatile than the forward market
c. because the forward market is more volatile than the spot market
d. because the spot market is less liquid than the forward market
e. none of the above

6. One of the major reasons for the existence of the forward market is to ________.
a. provide a location for all currency traders to assemble and trade
b. manage currency risk especially risk associated with a transaction
c. hedge transactions involving foreign currency that occurred in the past
d. prevent default in the transaction
e. none of the above
7. The perfect market assumptions include each of the following except ____.
a. equal access to market prices
b. equal access to costless information
c. frictionless markets
d. rational investors
e. stable governments