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Answers Foreign Exchange Problems Spring 2011

Answers Foreign Exchange Problems Spring 2011. Transaction 1 - Sale.

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Answers Foreign Exchange Problems Spring 2011

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  1. AnswersForeign ExchangeProblemsSpring 2011

  2. Transaction 1 - Sale Best Chocolate of Switzerland sells chocolates to Obese Candy Bars of the United States. Best will be paid $18,000,000 in 90 days. The present exchange rate is SF 0.9207/$1. The 90 day forward contract exchange rate is SF 0.9200/$1. The annual prime lending rate in USA is 3.25%. The annual deposit rate in USA is 0.65% per annum. Best’s cost of capital is 8.4% per annum.

  3. What could happen? • Value of transaction today in SF US$ 18,000,000 X SF 0.9207/$ = SF 16,572,600 • Appreciation of SF example US$ 18,000,000 X SF 0.9203/$ = SF 16,565,400 • Depreciation of SF example US$ 18,000,000 X SF 0.9217/$ = US$25,672,500 Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

  4. 90 Day Forward Contract US$18,000,000 X SF 0.9200/$ = SF 16,560,000 received in 90 days Need Present Value of this sale, must discount by Best Chocolate’s cost of capital Forward Value = SF 16,560,000 = SF 16,219,393 (1+ cost of capital ) (1 + .084 ) fraction of year 4

  5. Asset – Liability Hedging Best Chocolate has an Accounts Receivable, an Asset, and needs to match with a Liability, a 90 day loan in the USA. The logic is that after 90 days, the received payment will be sufficient to pay off the 90 bank loan principal plus interest. The amount to borrow in USA: Value of sale = US $18,000,000= US $17,854,929 (1 + borrowing rate) (1 + .0325 ) fraction of year 4 Amount of SF received from the US$ 17,854,929 bank loan Multiple today’s spot rate SF 0.9207/$ = SF 16,439,033

  6. Which to choose? • Forward Contract = SF 16,219,393 • Asset-Liability Hedging = SF 16,439,033 • Choose Asset-Liability Hedging – Receive more SF for the sale • Lessons • Must make financial calculations to make choice • Must determine present value of forward contract by discounting using firm’s cost of capital • No method of foreign exchange risk protection is always better than another, can only be determined through financial analysis

  7. Transaction 2 - Purchase OverPriced Watches purchases $7,500,000, of microchips from Bigtel in the USA, payable in 180 days. The spot exchange rate is SF 0.9207/$. The 180 day forward contract exchange rate is SF 0.9195/$. The annual prime lending rate in the USA is 3.25%. The annual bank deposit rate in the USA is .65% per annum. OverPriced cost of capital is 11.5% per annum.

  8. What could happen? • Value of transaction today in SF $ 7,500,000 X SF 0.9207/$ = SF 6,905,250 • Appreciation of SF $ 7,500,000 X SF 0.9203/$ = SF 6,902,250 • Depreciation of SF $ 7,500,000 X SF 0.9217/$ = SF 6,912,750 Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

  9. 180 Day Forward Contract $ 7,500,000 X SF 0.9195/$= SF 6,896,250 paid in 180 days Need Present Value of this payment, must discount by OverPriced’s cost of capital Forward Value = SF 6,896,250= SF 6,521,277 (1+ cost of capital ) (1 + .115) fraction of year 2

  10. Asset – Liability Hedging Best Chocolate has an Accounts Payable, a Liability, and needs to match with an Asset, a 180 day bank deposit in USA. The logic is that after 180 days, the bank deposit’s principal and interest will pay off the loan. The amount to borrow in USA: Value of deposit = $ 7,500,000= $ 7,475,704 (1 + deposit rate ) (1 + .0065 ) fraction of year 2 Amount of SF required for the $ 7,475,704 bank deposit Multiple today’s spot rate SF 0.92.0/$ X $ 7,475,704 = SF 6,882,881

  11. Which to choose? • 180 day Forward Contract = SF 6,521,277 • Asset-Liability Hedging = SF 6,882,881 • Choose Forward Contract – Pay less SF for the purchase • Lessons • Must make financial calculations to make choice • Must determine present value of forward contract by discounting using firm’s cost of capital • No method of foreign exchange risk protection is always better than another, can only be determined through financial analysis

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