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In the second half:-

Chapter 11, 14,16, 17, 21
Research Report
In class activity
Quiz - week 12
Final exam – week 13
Some facts
Exchange rate fluctuations affect the
value of a MNCs.
Value of your firm increases, if you
receive stronger currencies and pay in
weaker currencies.
There are some techniques available
to decrease the exchange rate risk.
MANAGING TRANSACTION
EXPOSURE (CH 11)
Agenda
Compare:-
Forward hedge
Money market hedge
Call option and Put option
In Class Activities
Selection of Hedging Techniques
 MNC must identify its degree of
transaction exposure.
 MNC must consider the various
techniques to hedge the exposure.
 Thus, it can decide which hedging
technique is optimal.
 Forward Hedging Payables and
Receivables
MNC may decide to hedge part or all of
their payables and receivables

Techniques – forward or future hedging

Differences –
◦ forward is negotiated between MNC and
commercial banks
◦ Future is negotiated/sold on the exchange
Forward Hedge on Payables
The contract will specify the:
• Currency that the firm will pay___________
• Currency that the firm will receive_________
• Amount of currency to be received by the
firm_______
• Rate at which the MNC will exchange
currencies (called the forward rate)_______
• Future date at which the exchange of
currencies will occur
• Advantage/disadvantage for the firm?
Forward Hedge on Payables
Allows an MNC to lock in a specific
exchange rate at which it can
purchase a specific currency.
Allows to hedge payables in a foreign
currency.

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 Forward Hedge on Payables
A US based company needs 100,000
Euros in three months.
The three months forward rate is $1.20.
If company purchases Euros 3 months
forward, its dollar cost in 3 months is :
Cost in $ = Payables x Forward Rate
=100,000 Euros x US$1.20
= $120,000
The Cost of Hedging
Three month after, the company is now
ready to make its payment but the spot
rate is now $1.18. If the company had not
hedge it would cost the company:
=100,000 Euros x US$1.18
= $118,000
The company’s cost of hedging is $120, 000 -
$118,000 =$2,000.
Forward Hedge on Receivables
 A US based MNC will receive 200,000 Swiss Franc in 6-
months.
 It could obtain a forward contract to sell SF 200,000 in 6-
months.
 The 6-month forward rate is $0.71.
 If company sells Swiss Franc 6-months forward, its estimated
amount of dollars to be received in 6-months is :
Cash inflow in $ = Receivable x Forward Rate
=SF 200,000 x $0.71
= $142,000
 Question
Your company will receive C$600,000 in
90 days. The 90-day forward rate in the
Canadian dollar is $.80. If you use a
forward hedge, you will:

C$600,000 ´ $0.80 = $480,000

Money Market Hedge-Payables
MNC with excess funds will use their
money create a money market hedge
How it works – it needs two hedge
position
• Borrow funds in the home currency
• Invest in the foreign currency
Money Market Hedge- Payables
 A company needs to pay 50,000 euros in 12 months and
can earn 5% on deposit, the spot rate is $1.18 and the
company can borrow at an interest rate of 8% 47,619
 Euro Deposit needed to hedge 50,000 euros
1 +.05 = 47,619
US dollar needed to purchase euro=
47, 619 x $1.18 = $56,190.
Cost to borrow =$56190 x(1 +.08) = $60,685.
 Question

Assume that Hampshire Co. has net payables of 200,000

Mexican pesos in 180 days. 
The Mexican interest rate is 7% over 180 days,
and the spot rate of the Mexican peso is $.10. 
Suggest how the U.S. firm could implement a money market
hedge. 
 Solution
 Peso Deposit needed to hedge 200,000 pesos
1 +.07 = 186,915

US dollar needed to purchase pesos=

186,915 x $0.10 = $18,691
Money Market Hedge- Receivables
How it works
◦ Borrow in the currency that it will be receive
◦ Use receivables to repay the loan
Money Market: Hedge Receivables
 A US based MNC will receive 200,000 Swiss Franc
in 6-months. The spot rate is $0.70. Assume it can
borrow in francs at a rate of 3%
 Amount to borrow SF200,000/(1+.03) =SF194,175
 It will owe the bank SF200,000 in 6 months

 Ifthe company does not have any immediate use

for the funds it could convert the funds to dollars
and invest it
◦ SF194,175 x $.70 =$138,640 the value of receivables in
6 months
 Question

Assume that Stevens Point Co. has net

receivables of 100,000 Singapore dollars
in 90 days.  The spot rate of the
S$ is $.50, and the Singapore interest
rate is 2% over 90 days. 
Suggest how the U.S. firm
could implement a money market hedge
 Solution
Amount to borrow S100,000/(1+.02)
=S98,039
Converted to dollars: S98,039 x$.50
=$49,019
Call Option Hedge on Payables
Currency call option provides the right to
buy a specified amount of currency at a
specific price, called exercise price.

The premium must be paid whether

the option is used or not.
Call Option Hedge on Payables
Cost of hedging with call options is not
known with certainty.
It is only known once the payables are
due.
MNCs calculate estimated cost of
option to compare the hedging
techniques.
 Cost of Call Options

◦ Advantage:
 provides an effective hedge
 The MNC is not obligated to exercise the option, but
can allow it expire if the spot rate is less than the
option rate

◦ Disadvantage: premium must be paid

Consideration of Alternative Call Options.

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 Example
 A company is considering hedging its payables of
100,000 euros. The call option has an exercise price of
$1.20 and premium of $.03 with an expiry date of a year.
 The company can create a contingency graft with a
forecast of possible spot rates.
 If the spot rate is less than $1.20 when the payable is
due the company will not exercise the call option but
instead pay the premium
 At a rate of $1.20 or more the company would exercise
the call of $1.20 and pay the premium of $.03, total
payout $1.23
Exhibit 11.1 Contingency Graph for Hedging Payables With
Call Options

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Cost of Call Options
 Based on Currency Forecast
◦ If company “A” hedges its payables of Euro 100,000 with
call option.
◦ Exercise price $1.20 and premium of $0.03
◦ Company forecasts the spot rate at the time when
payables are due
 $1.16 (20% probability)
 $1.22 (70% probability)
 $1.24 (10% probability)
Use of Currency Call Options for Hedging Euro
Payables (Exercise Price = $1.20, Premium = $.03)

(1) (2) (3) (4) (5)

Spot Rate Premium Amount Paid Dollar Amount
Scenario When Per Unit Per Unit Paid For
Payables Are Paid On (Including 100,000 Euro
Due Call Premium When Owning
Option When Owning A Call Option
A Call Option)

1 $1.16 $.03 $1.19 $119,000

2 1.22 .03 1.23 123,000

3 1.24 .03 1.23 123,000

 Example
 A company is considering hedging its payables of
100,000 euros. The call option has an exercise price of
$1.20 and premium of $.03 with an expiry date of a year.
 $1.16 (20% probability)
 $1.22 (70% probability)
 $1.24 (10% probability
 Expectedvalue of dollar cashflow:
 Expected Cost of Call Option = ($119,000* 20% )+
($123,000* 80%) = $122,200
 Question
 A U.S. company imports British goods and plans to purchase a call
option to hedge payables of 100,000 pounds in 90 days. Three call
options are available that have an expiration date 90 days from
now. Fill in the number of dollars needed to pay for the payables
(including the premium paid) for each option available under each
possible scenario in the following table? Substantiate your answer
with estimated costs for each type of hedge.
Scenario Spot rate of Exercise Exercise Exercise
pound 90 Price = Price = Price =
days from $1.74 $1.76 $1.79
now Premium = Premium = Premium =
$.06 $.05 $.03
1 $1.65      
2 $1.70      
3 $1.75      
4 $1.80      
5 $1.85      
 Solution
Scenario Spot rate of pound Exercise Price = Exercise Price = Exercise Price =
90 days from now $1.74 $1.76 $1.79
Premium = $.06 Premium = $.05 Premium = $.03

1 $1.65
$171,000
    $170,000   $168,000
2 $1.70
176,000
    175,000   173,000
3 $1.75
180,000
    180,000   178,000
4 $1.80
180,000
    181,000   182,000
5 $1.85
180,000
    181,000   182,000
Hedging Techniques - Comparison
Expected Cost of Call Option =
$122,200
Cost of Forward Contract = $120,000
Which hedging technique should
be selected?
Put Option Hedge on Receivables
 US-based MNC will receive 200,000 Swiss Franc in 6-
months.

 Itcould purchase put option with exercise price of $0.72

and premium of $0.02 and expiration date of 6 months
from now.
 At any spot more than exercise price of $0.72, MNC
would let the option expire and sell SF in Forex market.
 At a rate of $.72 or more the company would not exercise the call
of $.72 (received rate would be $.70) would be and pay the
premium of $.02
Put Option - Calculate
MNC decides to calculate the cost of
put option with exercise price $.72 and
premium $.02. Its probability
distribution of spot rate is
$.71 – 30%
$.74 – 40%
$.76 – 30%
Calculate expected value of cash to
be received?
 Put Option - Calculate
(Exercise Price = $.72; Premium = $.02)

Spot Rate Use Put Amount Received Amount Received For

Option SF200,000
$.71 Yes $.72 - $.02 = $.70 $.70*200,000= $140,000
$.74 No $.74 - $.02 = $.72 $.72*200,000=$144,000
$.76 No $.76 - $.02 = $.74 $.74*200,000=$148,000

Expected value of cash to be received :

$140,000*30% + $144,000*40% + $148,000*30% =
$144,000
Hedging Techniques - Comparison
Forward Contract = $142,000
Put Option = $144,000
 Question
As treasurer of Tucson Corp. (a U.S. exporter to New
Zealand), you must decide how to hedge (if at all) future
receivables of 250,000 New Zealand dollars 90 days from
now. Put options are available for a premium of $.03 per unit
and an exercise price of $.49 per New Zealand dollar. The
forecasted spot rate of the NZ$ in 90 days follows:
  Future Spot Rate Probability
 $.44 30%
 .40 50
 .38 20
 Given that you hedge your position with options, create a
probability distribution for U.S. dollars to be received in 90
days.
 The probability distribution represents a 100% probability of receiving
$115,000, based on the forecasts of the future spot rate of the NZ$.

      Amount    
      per Unit Total  
Possible Put Option Exercise Received Amount  
Spot Premium Option? Accounting Received Probability
Rate for for
Premium NZ$250,00
0
$.44 $.03 Yes $.46 $115,000 30%
$.40 $.03 Yes $.46 $115,000 50%
$.38 $.03 Yes $.46 $115,000 20%
 Your company will receive C$600,000 in 90 days. The 90-
day forward rate in the Canadian dollar is $.80. If you use
a forward hedge, you will:

A. Receive $750,000 today.

B. Receive $750,000 in 90 days.
C.Pay $750,000 in 90 days.
D.Receive $480,000 in 90 days.

Answer: D
 Foghat Co. of US has 1,000,000 Euros as receivables
due in 30 days, and is certain that the euro will
depreciate substantially over time. Assuming that the
firm is correct, the ideal strategy is to:

A. SellEuros forward.
B. Purchase euro currency call options.
C. Purchase Euros forward.
D. Remain unhedged.

Answer: A
 The real cost of hedging payables with a
forward contract equals:
A. The nominal cost of hedging minus the nominal cost of
not hedging.
B. The nominal cost of not hedging minus the nominal cost
of hedging.
C. The nominal cost of hedging divided by the nominal cost
of not hedging.
D. The nominal cost of not hedging divided by the nominal
cost of hedging.

Answer: A
 Quasik Corporation will be receiving 300,000 Canadian dollars
(C$) in 90 days. Currently, a 90-day call option with an exercise
price of $.75 and a premium of $.01 is available. Also, a 90-day put
option with an exercise price of $.73 and a premium of $.01 is
available. Quasik plans to purchase options to hedge its receivable
position. Assuming that the spot rate in 90 days is $.71, what is the
net amount received from the currency option hedge?
 A $219,000
 B $222,000
 C $216,000
 D $213,000
 C ($.73 - $.01) ´ 300,000 = $216,000.
 Question
 FAB Corporation will need 200,000 Canadian dollars (C$) in 90
days to cover a payable position. Currently, a 90-day call option
with an exercise price of $.75 and a premium of $.01 is available.
Also, a 90-day put option with an exercise price of $.73 and a
premium of $.01 is available. FAB plans to purchase options to
hedge its payable position. Assuming that the spot rate in 90 days is
$.71, what is the net amount paid, assuming FAB wishes to
minimize its cost?
 A $144,000
 B$158,000
 C$148,000
 D$152,000

A ($.71 + $.01) ´ 200,000 = $144,000.
 Question
 Samson Inc. needs €1,000,000 in 30 days. Samson can earn 5
percent annualized on a German security. The current spot rate for
the euro is $1.00. Samson can borrow funds in the U.S. at an
annualized interest rate of 6 percent. If Samson uses a money
market hedge, how much should it borrow in the U.S.?
 A. $952,381
 B $995,851
 C $943,396
 D $995,025
 B 1,000,000/[1 + (5% ´ 30/360) = $995,851