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Exam Foreign Exchange Problems Answers Spring 2011

Exam Foreign Exchange Problems Answers Spring 2011. Question No. 3 – Purchase Transaction.

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Exam Foreign Exchange Problems Answers Spring 2011

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  1. ExamForeign ExchangeProblems AnswersSpring 2011

  2. Question No. 3 – Purchase Transaction • Rickety Furniture of the United States has just made a major purchase of wood finishing equipment from Good Machinery of Osaka, Japan. Rickety Furniture will pay Good Machinery Japanese ¥ 25,000,000,000 in 180 days. Rickety Furniture has experienced losses in the past on such purchases because of movements in the foreign exchange rate between the Japanese ¥ and the US$. The current exchange rate is $.011786/1 Japanese ¥ and a 180 day forward contract is $.011802/1 Japanese ¥. The current annual deposit rate in Japan is .17% and the prime annual lending rate is 1.475%. Rickety Furniture's cost of capital is 7.50% per annum.

  3. What could happen? • Value of purchase transaction today in US$ ¥ 25,000,000,000 X US$ 0.011786/ ¥ = US$ 294,650,000 • Appreciation of US$ example ¥ 25,000,000,000 X US$ 0.01177/ ¥ = US$ 294,250,000 • Depreciation of US$ example ¥ 25,000,000,000 X US$ 0.0118/ ¥ = US$ 295,000,000 Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

  4. 180 Day Forward Contract ¥ 25,000,000,000 X US$ 0.011802/ ¥ = US$ 295,050,000 paid in 180 days Need Present Value of this forward contract, must discount by Rickety Furniture‘s cost of capital Forward Value = US$ 295,050,000= US$ 284,385,542 (1+ cost of capital ) (1 + .075 ) fraction of year 2

  5. Asset – Liability Hedging Rickety Furniture has an Accounts Payable, a Liability, and needs to match with an Asset, a 180 day bank depositin Japan. The logic is that after 180 days, the bank deposit plus interest will be sufficient to pay the Accounts Payable with Good Machinery of Japan. The amount to deposit in Japan: Value of purchase = ¥ 25,000,000,000 = ¥ 24,978,768,047 (1 + deposit rate) (1 + .0017 ) fraction of year 2 Amount of US$ needed for the ¥ 24,978,768,047 bank deposit Multiply by today’s spot rate US$ 0.011786/ ¥ = US$ 294,399,760

  6. Which to choose? • 180 Day Forward Contract = US$ 284,385,542 • Asset-Liability Hedging = US$ 294,399,760 • Choose 180 Day Forward Contract– Pay fewer US$ for the equipment purchase

  7. Question No. 4 – Sale Transaction • Rickety Furniture in the United States has just sold Japanese ¥ 2,500,000,000 of its furniture to Noboloney Hotels of Tokyo, Japan. Rickety Furniture will receive the payment for this sale in three months and would like to guard itself against movements in the foreign exchange rate between the US$ and the Japanese ¥. The current exchange rate is $.011786/1 Japanese ¥ and a three month forward contract is $.011793/1 Japanese ¥. The current annual deposit rate in Japan is .17% and the prime annual lending rate is 1.475%. Rickety Furniture's cost of capital is 7.50% per annum.

  8. What could happen? • Value of sale transaction today in US$ ¥ 2,500,000,000 X US$ 0.011786/ ¥ = US$ 29,465,000 • Appreciation of US$ example ¥ 2,500,000,000 X US$ 0.01177/ ¥ = US$ 29,425,000 • Depreciation of US$ example ¥ 2,500,000,000 X US$ 0.0118/ ¥ = US$ 29,500,000 Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

  9. 90 Day Forward Contract ¥ 2,500,000,000 X US$ 0.011793/ ¥ = US$ 29,482,500 received in 90 days Need Present Value of this forward contract, must discount by Rickety Furniture‘s cost of capital Forward Value = US$ 29,482,500= US$28,939,877 (1+ cost of capital ) (1 + .075 ) fraction of year 4

  10. Asset – Liability Hedging Rickety Furniture has an Accounts Receivable, an Asset, and needs to match with a Liability, a 90 day bank loan in Japan. The logic is that after 90 days, the payment on the Accounts Receivable with Good Machinery of Japan will be sufficient to pay the bank loan’s principal plus interest. The amount to borrow in Japan: Value of sale = ¥ 2,500,000,000 = ¥ 2,490,815,119 (1 + lending rate) (1 + .01475 ) fraction of year 4 Amount of US$ from the ¥ 2,490,815,119 bank loan Multiple today’s spot rate US$ 0.011786/ ¥ = US$ 29,356,747

  11. Which to choose? • 90day Forward Contract = US$ 28,939,877 • Asset-Liability Hedging = US$ 29,356,747 • Choose Asset-Liability Hedging – more US$ received from the sale transaction

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