Risk Management Strategy. John Oruongo. Time Frame. Short Run Intermediate Run Long Run. Measure of Exposure. Translation exposure Can be ignored Transaction exposure More important in the short run Hedging possible Economic exposure Net worth exposure Cash flow exposure.
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In 1986 the financial press reported that Lufthansa purchased $500 million of new U.S. aircraft in early 1985 with payment due in early 1986, one year later. The transaction hit the news because Lufthansa reportedly paid about DM 1,364 million which was more than the $500 million liability converted at the prevailing rate, $.447/DM or DM 1,118 million.
This happened because Lufthansa decided to hedge half of the purchase price using forward contracts at a time when the dollar subsequently depreciated against the DM.
Forward contract obligated Lufthansa to purchase dollars at $0.31/DM
The dollar however depreciated from $0.30/DM in March of 1985 to $0.45/DM in March of 1986
Payment in 1986 with 50% hedge
(500*0.5)/0.31 + (500*0.5)/0.45
= DM 1,362 million
=DM 1,613 million
=DM 1,111 million
Waterford Crystal, of Kilbarry, Ireland, exports specialty glassware to the U.S. It faces a potential disastrous situation in 1985 as the U.S. dollar began to sink against the Irish pound. A wine decanter that sold in the U.S. for $150 translated into 148 pounds in 1985, but by 1986 it translated to just 106 pounds
Waterford, however, locked in an exchange rate for a significant part of its anticipated U.S. receivables by buying forward contracts on the Irish pound in 1985. The forward position stretched out for two years or until 1987. In 1986, Waterford was able to translate $50 million in U.S. sales into 48 million pounds instead of the 37 million it would have reported at the current exchange rate. Financial hedges clearly cannot be sustained beyond the short run, however.