Need Help on Questions 47 Assume the following The current e

Need Help on Questions 4-7

Assume the following:

The current exchange rate for the Japanese yen is 110.05.

The 120-day US interest rate is 1.895%.

The 120-day Japanese interest rate is -.050%.

The 120-day forward rate for Japanese yen is 109.40.

A US firm is required to make a payment of ¥12,000,000 to a supplier in 120 days.

1. If the value of the Japanese yen does not change, what will the dollar cost of the payment be?

2a. Describe how the firm can hedge the transaction risk associated with the payment using a money market hedge.

b. What will the dollar cost of the payment be if the firm hedges the transaction risk with a money market hedge and the spot exchange rate for Japanese yen in 120 days turns out to be 109.00?

3a. Describe how the firm can hedge the transaction risk associated with the payment using a forward market hedge.

b. Explain what will happen using this forward market hedge if the spot exchange rate in 120 days is 109.00.

4. Describe how the firm can hedge the transaction risk associated with the payment using a currency option. (Specify whether the firm should buy a call or put option on the Japanese yen, what expiration date it should select, and other choices it must make in connection with this approach to managing the transaction risk.)

5. How could the firm hedge the transaction risk associated with this payment by exposure netting or funds adjustment?

6. How can the firm use leading or lagging to its advantage in connection with this payment?

7. How would the answers to the previous questions change in the firm expected to receive a payment of ¥1,000,000 in 120 days rather than making a payment?

Solution

The answer for the questions for 4-7.

4. Since it is forward contract the best way to hedge the transaction risk is to eliminate the foreign currency exposure by buying  ¥12,000,000 at the forward rate of 120 days at 109.4 to its bank at $ 109689.21.No matter what happens to the exchange rate over the next month the US firm is able to convert this amount of Yen .

However the forward rate contracts are often inaccessible for many small business since banks often quote unfavourable rate for smaller business as because the risk is borned by the bank as the firms will not fulfill the forward contracts.Firms which are not eligible for forward contracts can take the option of doing the hedging by the future contracts.

5.Exposure netting allows companies to manage its currency risk more holistically.Since if the company finds the correaltion between exposure currencies as postive then the company can apply the long short strategy for exposure netting.Since a postive correlation between two currencies on a long short approach will result in gains in one currency offsetting the losses in the other.Conversely if there is negative correlation between the two currencies then the long long strategy will result in effective hedge in the event of currency movement.

6.If the firm thinks that Yen will decline in value wait 120 days to purchase the Yen at the lower cost and make payment (lagging).However if the firm thinks that Yen will increase in value purchase Yen at the current exchange rate and make the payment today which is( leading).

7.Since the forward rate for the japanese yen is -.050% interest rate and the 120 day forward rate for the Yen is 109.40 therefore the value of the rate is rate (1+interest rate ) ie 109.4*(1-.050) ie 103.93 .

Since it will receive payment of Y1000000 which is about to decline then it will purchase at the lower cost which is Y 1000000/103.93 ie $ 9621.86 today.