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Managing Foreign Exchange Risk
 

Managing Foreign Exchange Risk

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    Managing Foreign Exchange Risk Managing Foreign Exchange Risk Document Transcript

    • MANAGING FOREIGN EXCHANGE RISK18/04/2011 An analysis of DanTech’s exposure to Foreign Exchange and Political Risk.
    • FIN928 Report Danial Munsoor 3259882 Table of Contents1. Company Overview ........................................................................................................... 32. Current Scenario ............................................................................................................... 33. Foreign Exchange Risk and its Sources ......................................................................... 44. Impact of changes in Foreign Exchange Rates on DanTech’s business ..................... 4 4.1 A Falling Domestic Exchange Rate ......................................................................................................4 4.2 A Rising Domestic Exchange rate .........................................................................................................55 Managing Foreign Exchange Risk ................................................................................... 5 5.1 Futures Market Hedge ............................................................................................................................5 5.2 Forward Market Hedge ...........................................................................................................................6 5.3 Options Market Hedge ............................................................................................................................8 5.4 Money Market Hedge ..............................................................................................................................96 The Best Hedging Strategy for DanTech ...................................................................... 107 Factors that affect Exchange Rates .............................................................................. 11 7.1 Interest Rates ........................................................................................................................................ 11 7.2 Economic Situation ............................................................................................................................... 11 7.3 Foreign Trade ........................................................................................................................................ 11 7.4 Shocks and Speculation ...................................................................................................................... 12 7.5 Wars and Natural Disasters ................................................................................................................ 128 Political Risk faced by DanTech .................................................................................... 129 Appendix .......................................................................................................................... 1410 References ....................................................................................................................... 16Case Study ............................................................................................................................. 18 Page 1 of 20
    • FIN928 Report Danial Munsoor 3259882PART ONE Page 2 of 20
    • FIN928 Report Danial Munsoor 32598821. Company Overview: DanTech is a UK based Computer Technology Company and is head-quartered in London. It develops, market, manufacture and distributes hardware and software systems which are designed to help the customers manage and grow their business operations. Currently it is operating locally (i.e. within UK) and is ranked as No.1 within the region. Since it operates in UK, DanTech incurs expenses in Pounds Sterling (£).2. Current Scenario: The CEO of DanTech feels that the company should now expand its operations into the US markets also. Due to limited knowledge about the US market, he decides to go into a Joint Venture (JV) with a renowned IT company in the US known as Eastern Digital Group Ltd. Under the terms and agreements the JV would be named as DanEast Ltd and would manufacture Trading Software for US Banks. DanTech will have 52% share, whereas Eastern Digital will have 48% share in the JV. The CEO of DanTech feels that the tag-team of DanTech and Eastern Digital will help both the companies in making large profits, thereby reducing the operation costs and risks as well. Due to the competition from British Companies, DanTech decided to bill their Exports (or Sales) in US Dollars ($) which will give rise to Foreign Exchange Risk. In other words, all transactions will take place through Eastern Digital and will be invoiced in US Dollars. On April 8th, 2011 DanTech exported a Trading Software to DanEast Ltd and invoiced the sale in local currency, $5m payable in 6 months. On the other hand, DanTech also decided to import ¥10m worth of micro - processing chips from Japan so that it can use those chips in its hardware systems. The amount would be payable in 6 Months and would be denominated in Japanese Yen (¥). Hence, in order to manage the foreign exchange risk, the Treasury Manager has advised that the company can use at least one of the following hedging techniques: Money Market Hedge Forward/Futures Options Page 3 of 20
    • FIN928 Report Danial Munsoor 3259882 However, these methods have been explained in detail in the later part of the report.3. Foreign Exchange Risk and its Sources: Foreign Exchange Risk is the risk caused by fluctuations in the exchange rates between currencies that affect the financial performance or position of an organization. It is very important for companies that are dealing in multiple currencies for e.g. a company exports to another country and the customer pays in his or her own (or home) currency. However, companies whose businesses rely on imported goods also face foreign exchange risk (CPA Australia, 2009:4). The Sources of Foreign Exchange Risk are as follows: Imports are payable in foreign currency Other Costs such as Capital Expenditure are incurred in foreign currency Revenue is received in foreign currency Other income such as interest, dividends and royalties are received in foreign currency Company‟s loans are denominated and payable in foreign currency Since DanTech will be also engaged in Cross-Border Transactions, it will be exposed to Foreign Exchange Risk.4. Impact of changes in Foreign Exchange Rates on DanTech’s business: Since DanTech is importing as well as exporting, it can have two possible outcomes: 4.1 A Falling Domestic Exchange Rate: When the Pound depreciates against the Japanese Yen, it will increase importing costs for DanTech. As mentioned above, DanTech imports ¥10m worth of micro processing chips, which is payable in 6 months. The Spot Rate at that time was £0.0073/¥. Suppose after 6 months the Spot Rate turned out to be £0.0075/¥, i.e. the £ depreciates relative to the ¥. In this case DanTech would be paying £75,000 (¥10,000,000 x 0.0075). If the Spot Rate after 6 Months turned out to be £0.0070/¥, i.e. the £ appreciates against the ¥, DanTech would be paying £70,000 (¥10,000,000 x 0.0070). In other words, DanTech would be worse off when Pound Page 4 of 20
    • FIN928 Report Danial Munsoor 3259882 depreciates against Japanese Yen, as it would require more Pounds to pay off ¥100m. 4.2 A Rising Domestic Exchange rate: When the Pound appreciates against the US Dollar, it will decrease DanTech‟s dollar revenue from exports. As mentioned above, DanTech exports a Trading Software worth $5m to DanEast, which is payable in 6 months. The Spot Rate at that time was £0.6111/$. Suppose after 6 months the Spot Rate turned out to be £0.6099/$, i.e. the £ appreciates relative to the $. In this case DanTech would be receiving £3,049,500 ($5,000,000 x 0.6099). If the Spot Rate after 6 Months turned out to be £0.6120/$, i.e. the £ depreciates against the $, DanTech would be receiving £3,060,000 ($5,000,000 x 0.6120). In other words, DanTech would be worse off when Pound appreciates against US Dollar as it would receive less Pounds for its exports.5 Managing Foreign Exchange Risk: It can be seen from the above example that DanTech is exposed to changes in Foreign Exchange Rates. This section explains in detail how the hedging strategies can be used by DanTech to manage foreign exchange risk. To develop a better understanding about the topic, graphs and numerical examples have been used. 5.1 Futures Market Hedge: Futures are similar to Forward Contracts except that they are standardized contracts in terms of contract size, delivery date and so on, whereas Forward Contracts are tailor-made (Hughes and Macdonald, 2002:458) As per the current scenario, it is not appropriate for DanTech to use Currency Future Contracts due to two main reasons: Firstly, the amounts will be paid and received after 6 months, which would be in the month of October. We can see from Appendix # 3 that there are no future contracts available for the month of October. Page 5 of 20
    • FIN928 Report Danial Munsoor 3259882 Secondly DanTech would have to engage in marking-to-market activity which would be a costly process for the company, and the daily cash flows would have to be invested at uncertain interest rates (Eun & Resnick, 2009:156)5.2 Forward Market Hedge: It protects a business itself unfavorable movements in exchange rates by allowing it to lock in an agreed Forward Rate. The transaction is deliverable on the agreed date. However, the drawback of this method is that the company has to fulfill the contract even if the movement in exchange rate is unfavorable (CPA Australia, 2009:5). As per the current scenario, DanTech is going to receive foreign currency ($) as well as pay foreign currency (¥) after 6 months. DanTech can hedge its risk in two ways: i. DanTech as an Exporter (Receive $): It can take a short position in a 6 month forward contract with a bank to sell $5m at a Forward Rate of £0.6130/$ (from Appendix #1). Here DanTech will be using the $5m which it will be receiving from DanEast Ltd after 3 months. Under Forward Market Hedge, DanTech is assured £3,065,000 (0.6130 x 5,000,000) because it has locked in a rate of £0.6130/$. The table below shows a few possible outcomes due to a falling or rising exchange rate: Spot Unhedged Forward Gains/Losses Rate (ST) Position Hedge £0.6126 £3,063,000 £3,065,000 £2,000 £0.6128 £3,064,000 £3,065,000 £1,000 £0.6130 £3,065,000 £3,065,000 £0 £0.6132 £3,066,000 £3,065,000 -£1,000 £0.6134 £3,067,000 £3,065,000 -£2,000 It can be seen from the table that as the Spot Rate decreases, DanTech will receive more Pounds. On the other hand if the Spot Rate increases, DanTech will receive less Pounds for its exports. Page 6 of 20
    • FIN928 Report Danial Munsoor 3259882 The graph above shows the Gains/Losses if DanTech enters in to a Forward Contract to sell US Dollars. It illustrates that if the Spot Rate falls below £0.6130/$, DanTech will be making a profit. On the other hand if the Spot Rate turns out to be more than £0.6130/$, DanTech would be incurring a loss.ii. DanTech as an Importer (Pay ¥): DanTech can take a long position in a 6 months forward contract to buy ¥10m at a Forward Rate of £0.0072/¥ (applied Cross-Rate formula by using the values in Appendix # 1). The table below shows a few possible outcomes due to a falling or rising domestic exchange rate: Spot Unhedged Forward Gains/Losses Rate (ST) Position Hedge £0.0068 -£68,000 -£72,000 -£4,000 £0.0070 -£70,000 -£72,000 -£2,000 £0.0072 -£72,000 -£72,000 £0 £0.0074 -£74,000 -£72,000 £2,000 £0.0076 -£76,000 -£72,000 £4,000 It can be seen from the table that as the Spot Rate decreases, DanTech will require more Pounds to pay off ¥10m. On the other hand if the Spot Rate increases, DanTech will require less Pounds to pay for its imports. Page 7 of 20
    • FIN928 Report Danial Munsoor 3259882 The graph above shows the Gains/Losses if DanTech enters in to a Forward Contract to sell Japanese Yen. It illustrates that if the Spot Rate falls below £0.0072/¥, DanTech will be incurring a loss by paying more Pounds. On the other hand if the Spot Rate turns out to be more than £0.0072/¥, DanTech would be making a profit by paying less Pounds.5.3 Options Market Hedge: It is an agreement that allows for the right but not the obligation to undertake to purchase or sell a foreign currency at an agreed future date. Here we assume that the Forward Exchange rate is the best predictor of future spot rate. i. DanTech as an Exporter (Receive $): Since DanTech is going to receive $5m, it can buy a 6 months Put Option with a strike price of £0.6135/$ (Rate Assumed) for a premium of £0.005/$. Since the Forward Rate (£0.6130/$) is less than the Strike Price (£0.6135/$), DanTech will most probably exercise the put option and sell $5m £3,067,500 (5,000,000 x 0.6135). Since DanTech paid a premium also, the option cost would be £26,531 (0.005 x 5,000,000 x 1.01625). Therefore the net pound proceed will be £3,040,969 (3,067,500 – 26,531). Page 8 of 20
    • FIN928 Report Danial Munsoor 3259882 ii. DanTech as an Importer (Pay ¥): Since DanTech is going to pay ¥10m, it can buy a 6 months Call Option with a strike price of £0.0065/¥ (Rate Assumed) for a premium of £0.0007/¥. Since the expected future spot rate (£0.0072/¥) is more than the strike price (£0.0065/¥), DanTech will most probably exercise the call option and buy ¥10m for £65,000 (10,000,000 x 0.0065). Since DanTech paid a premium also, the option cost would be £7,052 (0.0007 x 10,000,000 x 1.007375). Therefore DanTech will secure ¥10m for a maximum of £72,052 (65,000 + 7,052).5.4 Money Market Hedge: DanTech can also hedge its Foreign Exchange Risk by borrowing $ (i.e. Receivables) and lending ¥ (i.e. Payables). i. DanTech as an Exporter (Borrow $): The following data is available to the company as-at April 8th, 2011: The U.S. Prime Rate 3.25% per annum The U.K. Prime Rate 0.5% per annum Spot Rate £0.6113/$ Refer to Appendix # 1 and 4 DanTech can perform the money market hedge as follows: Borrow $4,959,863 = in the US for 6 months at a rate of 1.625% (i.e. 3.25%/2) Convert $4,959,863 into £3,031,964 at the current spot rate which is £0.6113/$. Invest £3,031,964 in the UK for 6 months at a rate of 0.25% (i.e. 0.5%/2) Collect $5m after 6 months from DanEast (JV) and use it to repay Dollar loan. Receive £3,039,543 (£3,031,964 x 1.0025) from investment after 6 months. Page 9 of 20
    • FIN928 Report Danial Munsoor 3259882 ii. DanTech as an Importer (Lend/Invest ¥): The following data is available to the company as-at April 8th, 2011: The U.K. Prime Rate 0.5% per annum Japan Prime Rate 1.48% per annum Spot Rate £0.0073/¥ Refer to Appendix # 1 and 4 DanTech can perform the money market hedge as follows: Borrow £72,731 in the UK for 6 months at a rate of 0.25% (i.e. 0.5%/2) and pay £72,912 after 6 months. Convert £72,731 into ¥9,963,204 at the current spot rate which is £0.0073/¥. Invest ¥9,963,204 = in Japan for 6 months at a rate of 0.74% (i.e. 1.48%/2). Receive ¥10m from investment after 6 months and use it to pay ¥10m which we owe to the supplier.6 The Best Hedging Strategy for DanTech: The table below summarizes the outcomes for using the different hedging strategies: Strategy DanTech as an Importer DanTech as an Exporter Forward Assured of paying £72,000 after Assured of receiving £3,065,000 after Market Hedge 6 months. 6 months. Money Assured of paying £72,912 after Assured of receiving £3,039,543 after Market Hedge 6 months 6 months Options Assured of paying £72,052 after Assured of receiving £3,040,969 after Market Hedge 6 months 6 months By looking at the above table it can be observed that DanTech is better off by using Forward Market Hedge because it is paying the least amount and receiving the highest amount as compared to the other hedging strategies. Page 10 of 20
    • FIN928 Report Danial Munsoor 32598827 Factors that affect Exchange Rates: A currencys exchange rate is its price in terms of another currency. Factors that affect exchange rates are determined by the supply and demand of currencies. However, the supply and demand in turn is influenced by a number of market factors which are as follows: 7.1 Interest Rates: Suppose that the interest rates in UK increase. This means that the government bonds will yield higher return and would thus attract foreign capital from overseas. Pound Sterling would have to be purchased in order to buy these securities which would increase the demand for Pound also. This would strengthen the Pound relative to other currencies (Lowery, 2008). 7.2 Economic Situation: Financial Institutions generally tend to move investments from weak economy into a stronger/stable economy. In other words if the economic indicators of a country like (for e.g. inflation and growth) are positive, tends to see an increasing demand for its currency. This in turn strengthens its exchange rate i.e. the Pound appreciates relative to other foreign currencies. The Pound has generally been stronger as compared to both the US Dollar and the Euro during the recent years, as its economy has done comparatively well (Lowery, 2008). 7.3 Foreign Trade: In order to buy UK goods, other countries must buy British Pounds. If the demand for British goods increases relative to our demand for foreign imports, the pound will tend to strengthen relative to other currencies. However, if the pound becomes strong, UK exports will become less attractive because UK goods will now become more expensive compared to other foreign goods (Lowery, 2008). Page 11 of 20
    • FIN928 Report Danial Munsoor 3259882 7.4 Shocks and Speculation: Exchange Rates are most likely to move quickly in response to unexpected surprises in the markets. They are at times perceived to be unrealistically high or low. For example, it is widely accepted that the Pound has been stronger (or overvalued) against the US Dollar and the Euro. If US goods seem extraordinarily cheap, and US importers reject UK goods as too expensive, and the British trade deficit is widening, then this gives rise to the suspicion that the pound is too strong (Lowery, 2008). 7.5 Wars and Natural Disasters: Natural Disasters and Wars are most likely to have an adverse effect the economy which in turn causes the exchange rate to decrease i.e. the demand for local currency decreases. On the other hand sanctions also cause the demand of the local currency to decrease because they limit the amount of international trade that a country can have with other countries (ArticlesBase, 2011).8 Political Risk faced by DanTech: Political risk can be simply defined as the loss of profit for DanTech due to change in a country‟s regulation or government. The sources of political risk are as follows: Non - Honoring of Government Guarantees: The government may not honor the contractual agreement with the lender/investor. For e.g. if DanTech invests in Japanese Bonds, the government may cancel the bond after sometime which exposes DanTech to a political risk. Civil Disturbance: It can arise due to strikes, elections, corruption/terrorism and revolutions. All this could result in Political Instability of a country which could in turn have an adverse effect on the economy. For e.g. if there are political riots in UK, DanTech‟s assets could be physically damaged. Page 12 of 20
    • FIN928 Report Danial Munsoor 3259882Currency Transfer and Convertibility:Inability to convert local currency into foreign currency as well as delays in acquiringforeign exchange due to host government‟s actions or failure to act (Austin, 2005).Restrictions on Foreign Direct Investment (FDI) Outflows in Home Country:In home countries Political Risk may arise from actions that are directly aimed atinvestment destinations such as Sanctions. The UK government may imposesanctions which would cause the demand for Pound to decrease because thegovernment is limiting amount of international trade that UK can have with othercountries (World Bank Group, 2010). This could have an adverse effect onDanTech as it would be allowed to import or export a limited amount of goods whichin turn could affect DanTech‟s profitability.Change in the Government:If UK has too many frequent changes in government as well as political parties, thegovernment policies may become inconsistent and discontinuous which may hindera country‟s international business (Saunders & Cornett, 2008:437).Expropriation/Nationalization:It is the elimination of ownership, control over or rights to the asset/investment(Austin, 2005). The risk of expropriation gained attention in the 1970s when theMNC‟s found themselves at the core of public scrutiny with operations nationalizedor controlled tightly (World Bank Group, 2010). DanEast‟s (i.e. the JV in US)operations may be nationalized by the US government which may result in loss ofownership and control for DanTech. Page 13 of 20
    • FIN928 Report Danial Munsoor 32598829 Appendix: Appendix # 1: EXCHANGE RATES U.S.-dollar foreign-exchange rates in late New York trading Country/currency IN US$ PER US$ Country/currency IN US$ PER US$ Americas Europe Argentina peso 0.247 4.0486 Czech Rep. koruna 0.05914 16.909 Brazil real 0.6364 1.5713 Denmark krone 0.1939 5.1573 Canada dollar 1.0446 0.9573 Euro area euro 1.4457 0.6917 1-mos forward 1.0438 0.958 Hungary forint 0.005491 182.12 3-mos forward 1.0423 0.9594 Norway krone 0.1852 5.3996 6-mos forward 1.0394 0.9621 Poland zloty 0.3649 2.7405 Chile peso 0.002128 469.92 Romania leu 0.3516 2.8445 Colombia peso 0.00055 1817.52 Russia ruble 0.03571 28.003 Ecuador US dollar 1 1 Sweden krona 0.161 6.2112 Mexico peso 0.0852 11.7316 Switzerland franc 1.0999 0.9092 Peru new sol 0.3574 2.798 1-mos forward 1.1001 0.909 Uruguay peso 0.0528 18.94 3-mos forward 1.1004 0.9088 Venezuela b. fuerte 0.232851 4.2946 6-mos forward 1.1007 0.9085 Asia-Pacific Turkey lira 0.6619 1.5107 Australian dollar 1.0535 0.9492 UK pound 1.6364 0.6111 China Yuan 0.153 6.5353 1-mos forward 1.6358 0.6113 Hong Kong dollar 0.1287 7.7711 3-mos forward 1.6343 0.6119 India rupee 0.02268 44.0917 6-mos forward 1.6314 0.6130 Indonesia rupiah 0.000116 8651 Middle East/Africa Japan yen 0.011786 84.85 Bahrain dinar 2.6526 0.377 1-mos forward 0.011788 84.83 Egypt pound 0.1676 5.9655 3-mos forward 0.011793 84.8 Israel shekel 0.291 3.4364 6-mos forward 0.011802 84.73 Jordan dinar 1.4109 0.7088 Malaysia ringgit 0.3309 3.0221 Kenya shilling 0.01194 83.75 New Zealand dollar 0.7821 1.2786 Kuwait dinar 3.6147 0.2766 Pakistan rupee 0.01177 84.962 Lebanon pound 0.000666 1501.5 Philippines peso 0.0233 42.9 Saudi Arabia riyal 0.2667 3.7495 Singapore dollar 0.7955 1.2571 South Africa rand 0.1504 6.6489 South Korea won 0.000924 1082.49 UAE dirham 0.2723 3.6724 Taiwan dollar 0.03457 28.927 Thailand baht 0.0333 30.03 Vietnam dong 0.00005 20830 SDR 1.5927 0.6300 Source: Closing Values on April 08, 2011 from Wall Street Journal Page 14 of 20
    • FIN928 Report Danial Munsoor 3259882Appendix # 2: CURRENCY CROSS RATES USD EUR GBP CHF PESO JPY CAD Canada 0.9573 1.384 1.5665 1.0529 0.0816 0.0113 - Japan 84.846 122.66 138.84 93.323 7.2323 - 88.631 Mexico 11.732 16.96 19.198 12.904 - 0.1383 12.255 Switzerland 0.9092 1.3144 1.4878 - 0.0775 0.0107 0.9497 U.K. 0.6111 0.8835 - 0.6721 0.0521 0.0073 0.6384 Euro 0.6917 - 1.1319 0.7608 0.059 0.0082 0.7226 U.S. - 1.4457 1.6364 1.0999 0.0852 0.0118 1.0446 Source: Closing Values on April 8,2011 from Wall Street JournalAppendix # 3: CURRENCY FUTURESJapanese Yen (CME)-¥12,500,000; $ per 100¥ Swiss Franc (CME)-CHF 125,000; $ per CHF Open High Low Settle Chg Open Int Open High Low Settle Chg Open Int 11-Jun 1.1766 1.1814 1.1714 1.1793 0.0014 127,520 11-Jun 1.0916 1.1042 1.0912 1.0993 0.0075 58,701 11-Sep 1.179 1.1822 1.1724 1.1802 0.0013 916 11-Sep 1.0976 1.1041 1.0923 1.0997 0.0073 71 11-Dec 1.0963 1.1017 1.096 1.0999 0.0071 15Canadian Dollar (CME)-CAD 100,000; $ per CAD Australian Dollar (CME)-AUD 100,000; $ per AUD Open High Low Settle Chg Open Int Open High Low Settle Chg Open Int 11-Jun 1.0415 1.0481 1.0407 1.0428 0.0016 137,635 11-Jun 1.0381 1.05 1.0369 1.0437 0.007 150,827 11-Sep 1.0407 1.0452 1.038 1.0399 0.0015 2,428 11-Sep 1.026 1.0364 1.0243 1.0308 0.0068 717 11-Dec 1.0358 1.0422 1.0352 1.0366 0.0013 2,429 Mexican Peso (CME)-MXN 500,000; $ per 10MXN 12-Mar 1.0371 1.0382 1.0335 1.0332 0.0012 198 Open High Low Settle Chg Open Int 12-Jun 1.0312 1.0342 1.03 1.0298 0.0013 26 11-Apr ... ... ... 0.852 0.003 0 11-Jun 0.8445 0.84875 0.8435 0.8465 0.003 164,038British Pound (CME)-£62,500; $ per £ Euro (CME)-€125,000; $ per € Open High Low Settle Chg Open Int Open High Low Settle Chg Open Int 11-Jun 1.6307 1.6414 1.63 1.6336 0.0035 112,126 11-Jun 1.4282 1.4468 1.427 1.4414 0.0136 239,743 11-Sep 1.628 1.6378 1.628 1.6306 0.0036 149 11-Sep 1.4275 1.4421 1.4233 1.4371 0.0132 2,003 11-Dec 1.6328 1.6328 1.6281 1.6276 0.004 37 Source: Closing Values on April 8, 2011 from Wall Street JournalAppendix # 4: PRIME RATES Lender Rate U.S. 3.25% Canada 3.00% Euro zone 1.25% Japan 1.48% Switzerland 0.52% Britain 0.50% Australia 4.75% Hong Kong 5.25% Source: Wall Street Journal April 11, 2011 Page 15 of 20
    • FIN928 Report Danial Munsoor 325988210 References:CPA Australia, 2009, „A guide to managing foreign exchange risk‟, Available:http://www.cpaaustralia.com.au/cps/rde/xbcr/cpa-site/Guide_to_managing_foreign_exchange_risk_.pdf [Accessed 8th April, 2011]AriclesBase, 2011, „Factors that affect foreign exchange rates‟, Available:http://www.articlesbase.com/currency-trading-articles/factors-that-affect-foreign-exchange-rates-4325340.html [Accessed 11th April, 2011]Lowery, A. 2008, „This is Money‟, What makes currencies strong or weak, Available:http://www.thisismoney.co.uk/markets/article.html?in_article_id=429456&in_page_id=3[Accessed 13th April, 2011]Austin, T. 2005, „Mitigating Political Risks in Large Infrastructure Projects‟, Available:http://www.sapp.co.zw/documents/Mitigating%20political%20risks%20in%20large%20projects.pdf [Accessed 12th April, 2011]World Bank group, 2009, „World Investment and Political Risk‟, Available:http://www.miga.org/documents/flagship09ebook.pdf [Accessed 16th April, 2011]Hughes, J. & Macdonald, S. 2002, International Banking Text and Cases, Pearson Education,Boston.Saunders, A. and Cornett.M, 2008, „Sovereign Risk‟, Financial Institutions Management,McGraw Hill, Singapore, pp. 437 Page 16 of 20
    • FIN928 Report Danial Munsoor 3259882PART TWO Page 17 of 20
    • FIN928 Report Danial Munsoor 3259882 CASE STUDYAirbus sold an aircraft, A400, to Delta Airlines, a US Company, and billed $30 millionpayable in six months. Airbus is concerned with the euro proceeds from internationalsales and would like to control exchange risk. The current spot exchange rate is $1.05/€and six-month forward exchange rate is $1.10/€ at the moment. Airbus can buy a six-month put option on US Dollars with a strike price of €0.95/$ for a premium of €0.02 perUS Dollar. Currently, six-month interest rate is 2.5% in the euro zone and 3.0% in the US. Airbus Invoiced $30m Delta Airlines ($ Receivable) ($ Payable) 6M US Interest Rate 3.0% 6M Euro Zone Interest Rate 2.5% Spot Rate $1.05/€ 6M Forward Rate $1.10/€ Strike Price €0.95/$a. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forwards contract. Under Forward Contract, Airbus will be assured = = €27,272,727.27b. If Airbus decides to hedge using money market instruments, what action does Airbus needs to take? What would be the guaranteed euro proceeds from the American sale in this case? Since Airbus is going to receive $ (Foreign Currency), it can borrow $ now. However, the borrowed amount would be the Present Value of $ receivable i.e. = $29,126,213.59. After this it can convert $29,126,213.59 into €27,739,251.04 (29,126,213.59/1.05) at the spot rate of $1.05/€ and it in Euro Zone at an interest rate of Page 18 of 20
    • FIN928 Report Danial Munsoor 3259882 2.5%. After 6 months the investment will grow to €28,432,732.31. After 6 months, Airbus will collect $30m from Delta Airlines and will use it to pay the $ loan. Guaranteed Euro Proceeds = €27,739,251.04c. If Airbus decides to hedge using put options on US Dollars, what would be the “expected” euro proceeds from the American sale? Assume that Airbus regards the current forwards exchange rate as an unbiased predictor of the future spot exchange rate. Since Airbus is going to receive $ (Foreign Currency), it will go for a Put Option which will give Airbus the right to sell $ at a certain rate after 6 months. Since it assumes the forward rate is the best predictor of future spot rate, it must compare the exercise price with the forward rate. Since the forward rate ( ) is less than the strike price (€0.95/$) might exercise the option and sell $30m for €28,500,000 (30000000 x 0.95). However, it will also incur a cost of €615,000 (30000000 x 0.02 x 1.025). Therefore the net “expected” euro proceeds from American sale would be €27,885,000 (28500000 – 615000).d. At what future spot exchange rate do you think Airbus will be indifferent between the option and money market hedge? The rate at which Airbus would be “indifferent” between option and money market hedge can be calculated as follows: € (30,000,000) – 615,000 = 28,432,732.31 = = €0.9683/$ Therefore, Airbus would be indifferent between money market hedge and options at a Break Even/Future Spot Rate of €0.9683/$. Page 19 of 20