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FINC6013 Workshop 6 Questions & Solutions

Chapter 3

PROBLEMS

6. 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, and that the standard deviation of 90-day forecasts of the percentage rate of depreciation of the dollar relative to the yen is 4%.

a. Provide a qualitative description of Intel’s transaction exchange risk.

Answer: Intel is a U.S. company, and it is scheduled to receive yen in the future. A weakening of the yen versus the dollar causes a given amount of yen to convert to fewer dollars in the future. This loss of value could be severe if the yen depreciates by a significant amount.

b. If Intel chooses not to hedge its transaction exchange risk, what is Intel’s expected dollar revenue?

Answer: If Intel chooses not to hedge, the expected dollar revenue is the expected dollar value of the ¥100,000,000. The expected spot rate incorporates a 1% weakening of the dollar. This means that the expected yen price of the dollar is 1% less than the current spot rate of ¥103/$ or Et[S(t+90,¥/$)] = 0.99 [pic]¥103/$ = ¥101.97/$

Hence, Intel expects to receive ¥100,000,000 / ¥101.97/$ = $980,681

c. If Intel does not hedge, what is the range of possible dollar revenues that incorporates 95.45% of the possibilities?

Answer: We are told that the standard deviation of the rate of depreciation of the dollar is 4%. The standard deviation of the future spot rate is therefore 4% of the current spot rate or 0.04 [pic]¥103/$ = ¥4.12/$. Thus, plus or minus 2 standard deviations around the conditional expected future spot rate is ¥101.97/$ + ¥8.24/$ = ¥110.21/$

¥101.97/$ - ¥8.24/$ = ¥93.73/$
The range that encompasses 95.45% of possible future values for Intel’s receivable is therefore ¥100,000,000 / ¥110.21/$ = $907,359
¥100,000,000 / ¥93.73/$ = $1,066,894

Chapter 6

QUESTIONS

12. What is a money market hedge? How is it constructed?

Answer: In a money market hedge you offset the underlying transaction exchange risk with borrowing or lending in the foreign money market rather than with a forward market transaction. For example, if the underlying business transaction gives you a liability in foreign currency, you can borrow domestic currency, convert the principal from the borrowing into foreign currency, and invest the foreign currency thereby acquiring a foreign currency asset that is equivalent in value to the underlying foreign currency liability. You would want to borrow an amount of domestic currency equal to the present value of the foreign currency liability when converted at the spot exchange rate.

13. Suppose you are the French representative of a company selling soap in Canada. Describe your foreign exchange risk and how you might hedge it with a money market hedge.

Answer: As a French company, you are interested in euro profits. Selling soap in Canada will give you Canadian dollar revenues. The euro value of these Canadian dollar revenues will fall in value if the Canadian dollar weakens relative to the euro. To offset this loss in value, your company should borrow in Canadian dollars.

PROBLEMS

7. Assume that you are an importer of grain into Japan from the United States. You have agreed to make a payment in dollars, and you are scheduled to pay $377,287 in 90 days after you receive your grain. You face the following exchange rates and interest rates:

|Spot exchange rate: |¥106.35/$ | |90-day forward exchange rate: |¥106.02/$ | |90-day dollar interest rate: |3.25% p.a. | |90-day yen interest rate: |1.9375% p.a. |

a. Describe the nature and extent of your transaction foreign...
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