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

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Answers foreign exchange problems spring 2011

AnswersForeign ExchangeProblemsSpring 2011


Transaction 1 sale
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.


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


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


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


Which to choose
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


Transaction 2 purchase
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.


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


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


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


Which to choose1
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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