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As a manager of a U.S. domestic company, you are concerned about foreign currency exposure of your firm’s sales to the United Kingdom. You currently export $10 million of products to the United Kingdom annually and receive payment in pounds sterling. You send two large shipments each year valued at $5 million each. The invoice carriers net 90-day terms. Thus, from the invoice date, your company is exposed to currency exchange risk for a period of 90 days.

You are considering the possibility of using futures, options, or futures options as possible hedging tools. Your broker recently sent you the following data on the various hedging contracts available for your June 1 invoice with payments due September 1.

Current exchange rate (June 1) $1.67 per pound

Assumed spot exchange rate on September 1 is $2.00

$90-day forward rate as of June 1: $1.65

Options (31,250)

Striking price

June 1, September

Call Premium

Call Premium

September 1

165.0

4.35

35.00

170.0

2.40

30.00

175

1.20

25.00

Future options (62,500)

Striking price

June 1, September

Call Premium

Call Premium

September 1

1650

4.12

33.00

1700

2.20

27.00

1750

1.06

22.00

Future (62,500)

June 1

Settle

September 1

Settle

September

1.6496

2.055

c. Assume you hedge with a future options contract. Calculate the net result from the change in the in exchange rates from June 1 to September 1. Assume commission fees equal $60.

d. Assume you enter into a 90 day forward rate agreement. Calculate the net result from the hedge assuming that the fee for the agreement is $150.

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Patrina Schowalter
Patrina SchowalterLv2
28 Sep 2019

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Question: As a manager of a U.S. domestic company, you are c...

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As a manager of a U.S. domestic company, you are concerned about foreign currency exposure of your firm’s sales to the United Kingdom. You currently export $10 million of products to the United Kingdom annually and receive payment in pounds sterling. You send two large shipments each year valued at $5 million each. The invoice carriers net 90-day terms. Thus, from the invoice date, your company is exposed to currency exchange risk for a period of 90 days.

You are considering the possibility of using futures, options, or futures options as possible hedging tools. Your broker recently sent you the following data on the various hedging contracts available for your June 1 invoice with payments due September 1.

Current exchange rate (June 1) $1.67 per pound

Assumed spot exchange rate on September 1 is $2.00

$90-day forward rate as of June 1: $1.65

Options (31,250)

Striking price

June 1, September

Call Premium

Call Premium

September 1

165.0

4.35

35.00

170.0

2.40

30.00

175

1.20

25.00

Future options (62,500)

Striking price

June 1, September

Call Premium

Call Premium

September 1

1650

4.12

33.00

1700

2.20

27.00

1750

1.06

22.00

Future (62,500)

June 1

Settle

September 1

Settle

September

1.6496

2.055

a. Assume you don’t hedge. Calculate the dollar loss occurring from the change in exchange rates from June 1 to September 1.

b. Assume you hedge with an options contract. Calculate the net result from the change in the exchange rates from June 1 to September 1. Assume commission fees equal $60.

c. Assume you hedge with a futures option contract. Calculate the net result from the change in the exchange rate from June 1 to September 1. Assume commission fees equal $60.

d. Assume you hedge with a futures contract. Calculate the net result from the hedge assuming that the margin for one contract is $1,000 and roundtrip commission fees equal $60.

e. Assume you enter into a 90-day forward rate agreement. Calculate the net result from the hedge assuming that the fee for the agreement is $150.

Mega Fund
Mega Fund invests in stocks of US companies. With uncertainty in the world economy and in the US economy in particular, the US stock market has been quite volatile. The
current portfolio value of Mega Fund is $120 million. Brian, the portfolio manager is concerned about the volatility of stock prices and is thinking of obtaining portfolio
insurance. He also would like to diversify his holdings. With the downgrading of bonds issued in Europe, he believes that investing in bonds issued in Europe would be a good
investment and also diversify the fund holdings. Accordingly, he wants to borrow $125 million and invest in bonds of European firms for 5 years. The average yield from these bonds is 10%. However, these bonds are denominated in euro and all cash flows will occur in euros. Thus, Brian is concerned about the exchange rate risk he will be
undertaking if he invests in European bonds. He also would like to hedge the exchange rate risk through a currency swap. He has collected the following information:
On 1 April, S & P 500 Index is at 2,350. On the same day S & P futures are trading at 2,400 and S & P call options with exercise price of 2,400 is trading at 30. S & P put
options with exercise price of 2400 are trading at 60. Futures and options have a contract multiplier of 100. The options are American options.
The exchange rate on 1 April is Euro 1 = USD1.25 and the foreign exchange rate used for the beginning and end of a currency swap is the same. The swap rates are 5% USD
and 5% Euro.

Question 1
Brian would like to insure portfolio value at $120,000,000 on 1 April.
(a) Show how he can accomplish this by using S&P futures and how many futures contracts are needed.

(b) Show how he can accomplish this using S&P options and how options contracts are needed.

(c) Which of these methods is preferable? Explain why.

Question 2
If Brian enters into a currency swap contract,
(a) Explain how this helps Mega Funds from facing currency risk.
(b) Show clearly the initial cash flow, periodic cash flows, and terminal cash flow resulting from the currency swap.

Question 3
Consider the firm you work for, or another firm whose operations you are familiar with. Briefly describe its operations. What type of financial risks does that firm face?
How can you hedge against those risks? What are the constraints in hedging against those risks? Do the costs and benefits of the hedging strategy you recommend justify
hedging? Substantiate your response

Short Answer 1-8 [10 points each and each about 1/2 – 1 page double-spaced]:

1. If the spot rate for the Swiss Franc is that 1.05 SF is equal to 1 US $, and the annual interest rate on fixed rate one-year deposits of SF is 0.15% and for US$ is 1.5%, what is the nine-month forward rate for one dollar in terms of SFs? Assuming the same interest rates, what is the 18-month forward rate for one SF in US$s? Is this an indirect or a direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the SF get stronger or weaker against the dollar? What does this indicate about the market’s inflation expectations for Switzerland as compared to the United States economy?

2. On June 1st, 2017, Sandoz expects to ship 3 million units of a new drug from its Swiss plant to the US that it will sell through pharmacies on 270-day terms at $95 each. Therefore Sandoz will receive payment from these outlets on February 25th, 2018. Assuming that Sandoz needs to cover its expenses in Switzerland and thus wants to hedge its SF/US$ exposure using a forward contract with a Swiss bank, what is the minimum amount of Swiss Francs they should receive on February 25th, 2018 given 9-month forward rate you calculated in problem one for one US $ in terms of SF? What are two other ways Sandoz might hedge its SF/US$ exposure?

3. In his book Manias, Panics and Crashes (see the Introduction and Chapters posted on the class website) Charles Kindleberger explains the three stages of how a financial crisis develops and evolves over time. Please briefly explain these stages and how the Baltic and Mexican Tequila Crises as presented in Hill text and class case presentation follow this economic pattern or paradigm.

4. Toyota, whose global sales are generally dollar denominated, finds it has excess cash of $85,000,000,000, which it can invest for up to three years. It has determined that its best options are either a three-year Euro-dollar ($) deposit paying 2.65% or a three-year Yen denominated deposit paying 1.55% since it expects the Yen to appreciate 1.2% per annum against the dollar over the next three years. Using cash flow analysis determine the best currency option in which Toyota should invest. Be sure to show your complete calculations of the annual return on each investment possibility at the end of the three-year term. Assume that the annual interest amount is reinvested, i.e. compounds, at the same annual interest rate. Would your answer change if Toyota revised its outlook for the Yen to appreciate 1.1% per year? Show all calculations!!!

5. Country A has 20,000 units of labor and can produce 2 goods, manufactures and food. A’s producers take 5 units of labor to produce one unit of manufactures and 2 units to produce one unit of food. Country B has 30000 units of labor and takes 3 units to produce one unit of manufactures and 3 units to produce one unit of food. What is price of manufactures in terms of food at which A and B would respectively supply manufactures? What would B export in Adam Smith’s world? What is the amount it could supply?

6. Companies can be hurt by rapid changes in exchange rates even if their initial hedging actions appear reasonable. Explain how the VW case reflects this situation and what it could have done differently to manage the adverse impact of dollar depreciation. 7. Explain how Timberland developed global supply chain problems and then how they developed new logistical and partner relationships that used both IT and a changed physical distribution system to solve these issues.

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