Chapter 19 Foreign Exchange Risk: 1. Objectives
Chapter 19 Foreign Exchange Risk: 1. Objectives
Chapter 19 Foreign Exchange Risk: 1. Objectives
1. Objectives
356
Foreign
Exchange
Risk
4. Purchasing
power parity
5. Interest rate
parity
6. Expectations
theory
7. International
Fisher
Effect
357
2. Exchange Rate Systems
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3. Types of Foreign Currency Risk
(Pilot, Dec 09, Jun 13)
3.1 Currency risk occurs in three forms: transaction exposure (short-term),
economic exposure (effect on present value of longer term cash flows) and
translation exposure (book gains or losses).
3.2.2 Example 1
A UK company, buy goods from Redland which cost 100,000 Reds (the
local currency). The goods are re-sold in the UK for £32,000. At the time of
the import purchases the exchange rate for Reds against sterling is 3.5650 –
3.5800.
Required:
Solution:
(a) The UK company must buy Reds to pay the supplier, and so the bank
is selling Reds. The expected profit is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.5650) 28,050.49
Expected profit 3,949.51
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(b)(i) If the actual spot rate for the UK company to buy and the bank to sell
the Reds is 3.0800, the result is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 3.0800) 32,467.53
Loss (467.53)
(b)(ii) If the actual spot rate for the UK company to buy and the bank to sell
the Reds is 4.0650, the result is as follows.
£
Revenue from re-sale of goods 32,000,00
Less: Cost of 100,000 Reds in sterling (÷ 4.0650) 24,600.25
Profit 7,399.75
This variation in the final sterling cost of the goods (and thus the profit)
illustrated the concept of transaction risk.
3.2.3 A firm decide to hedge – take action to minimize – the risk, if it is:
(a) a material amount
(b) over a material time period
(c) thought likely exchange rates will change significantly.
3.2.4 As transaction risk has a potential impact on the cash flows of a company,
most companies choose to hedge against such exposure. Measuring and
monitoring transaction risk is normally an important component of treasury
management.
3.3.2 For example, a UK company might use raw materials which are priced in US
dollars, but export its products mainly within the EU. A depreciation of
sterling against the dollar or an appreciation of sterling against other EU
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currencies will both erode the competitiveness of the company. Economic
exposure can be difficult to avoid, although diversification of the supplier
and customer base across different countries will reduce this kind of
exposure to risk.
4.1 Changes in exchange rates result from changes in the demand for and supply
of the currency. These changes may occur for a variety of reasons, e.g. due to
changes in international trade or capital flows between economies.
(國際收支平衡是一個帳目,把一個國家與其他國家的交易記錄下來。這
個記錄主要是記下一些涉及金錢或有價值的經濟活動,好些沒有金錢的經
濟活動,如甲國有五萬人移民往乙國,這是不會記下的。)
4.3 Thus a country with a current account deficit where imports exceed exports
may expect to see its exchange rate depreciate, since the supply of the
currency (imports) will exceed the demand for the currency (exports).
4.4 There are also capital movements between economies. These transactions
are effectively switching bank deposits from one currency to another.
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These flows are now more important than the volume of trade in goods and
services.
4.5 Thus supply/demand for a currency may reflect events on the capital account.
Several factors may lead to inflows or outflows of capital:
(a) changes in interest rates: rising (falling) interest rates will attract a
capital inflow (outflow) and a demand (supply) for the currency
(b) inflation: asset holders will not wish to hold financial assets in a
currency whose value is falling because of inflation.
PPP predicts that the country with the higher inflation will be subject to a
depreciation of its currency.
Formally, if you need to estimate the expected future spot rates, PPP can be
expressed in the following formula:
S1 1 + hc
=
S 0 1 + hb
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base
country)
hc = Inflation rate in the other country (country currency).
4.6.2 Example 2
An item costs $3,000 in the US.
Assume that sterling and the US dollar are at PPP equilibrium, at the current
spot rate of $1.50/£, i.e. the sterling price x current spot rate of $1.50 =
dollar price.
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The spot rate is the rate at which currency can be exchanged today.
The US market The UK market
Cost of item now $3,000 $1.50 £2,000
Estimated inflation 5% 3%
Cost in one year $3,150 £2,060
The law of one price states that the item must always cost the same.
Therefore in one year:
$3,150 must equal £2,060, and also the expected future spot rate can be
calculated:
$3,150 / £2,060 = $1.5291/£
By formula:
S1 1 + 5%
=
1.50 1 + 3%
S1 = $1.5291
Solution:
The index compares local Big Mac prices with the price of Big Macs in
America. This comparison is used to forecast what exchange rates should
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be, and this is then compared with the actual exchange rates to decide which
currencies are over and under-valued.
4.6.5 PPP can be used as our best predictor of future spot rates; however it suffers
from the following major limitations:
(a) the future inflation rates are only estimates
(b) the market is dominated by speculative transactions (98%) as opposed
to trade transactions; therefore PPP breaks down
(c) government intervention – governments may manage exchange rates,
thus defying the forces pressing towards PPP.
4.6.6 However, it is likely that the PPP may be more useful for predicting
long-run changes in exchange rates since these are more likely to be
determined by the underlying competitiveness of economies, as measured by
the model.
(Jun 11)
4.7.1 Interest Rate Parity (IRP)
The IRP claims that the difference between the spot and the forward
exchange rates is equal to the differential between interest rates available in
the two currencies.
IRP predicts that the country with the higher interest rate will see the
forward rate for its currency subject to a depreciation.
4.7.2 Example 3
UK investor invests in a one-year US bond with a 9.2% interest rate as this
compares well with similar risk UK bonds offering 7.12%. The current spot
rate is $1.5/£.
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When the investment matures and the dollars are converted into sterling,
IRP states that the investor will have achieved the same return as if the
money had been invested in UK government bonds.
In 1 year, £1.0712 million must equate to $1.638 million so what you gain
in extra interest, you lose on an adverse movement in exchange rates.
The forward rates moves to bring about interest rate parity amongst
different currencies:
$1.638 ÷ £1.0712 = $1.5291
By formula:
F0 1 + 9 .2 %
=
1.5 1 + 7.12%
F0 = $1.5291
4.7.3 The IRPT generally holds true in practice. There are no bargain interest rates
to be had on loans/deposits in one currency rather than another. However, it
suffers from the following limitations:
(a) government controls on capital markets
(b) controls on currency trading
(c) intervention in foreign exchange markets.
4.7.4 The interest rate parity model shows that it may be possible to predict
exchange rate movements by referring to differences in nominal exchange
rates. If the forward exchange rate for sterling against the dollar was no higher
than the spot rate but US nominal interest rates were higher, the following
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would happen:
(a) UK investors would shift funds to the US in order to secure the higher
interest rates, since they would suffer no exchange losses when they
converted $ back to £.
(b) the flow of capital from the UK to the US would raise UK interest rates
and force up the spot rate for the US$.
4.9.1 The International Fisher Effect claims that the interest rate differentials
between two countries provide an unbiased predictor of future changes in the
spot rate of exchange.
4.9.2 The International Fisher Effect assumes that all countries will have the same
real interest rate, although nominal or money rates may differ due to expected
inflation rates. Thus the interest rate differential between two countries should
be equal to the expected inflation differential. Therefore, countries with higher
expected inflation rates will have higher nominal interest rates, and vice versa.
4.9.3 The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher
interest rates are considered necessary to compensate for the anticipated
currency depreciation.
4.9.4 Given free movement of capital internationally, this idea suggests that the real
rate of return in different countries will equalize as a result of adjustments to
spot exchange rates. The International Fisher Effect can be expressed as:
1 + ia 1 + ha
=
1 + ib 1 + hb
Where: ia = the nominal interest rate in country a
ib = the nominal interest rate in country b
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ha = the inflation rate in country a
hb = the inflation rate in country b
4.10.1 The four theories can be pulled together to show the overall relationship
between spot rates, interest rates, inflation rates and the forward and expected
future spot rates. As shown above, these relationships can be used to forecast
exchange rates.
5.2.1 Insist all customers pay in your own home currency and pay for all imports in
home currency. This method:
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(a) transfer risk to the other party
(b) may not be commercially acceptable.
5.3 Do nothing
5.3.1 In the long run, the company would “win some, lose some”. This method
(a) works for small occasional transactions
(b) saves in transaction costs
(c) is dangerous.
5.5.1 When a company has receipts and payments in the same foreign currency due
at the same time, it can simply match them against each other. It is then only
necessary to deal on the foreign exchange (forex) markets for the unmatched
portion of the total transactions.
Suppose that ABC Co has the following receipts and payments in three months
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time:
5.5.2 Netting only applies to transfers within a group of companies. Matching can
be used for both intra-group transactions and those involving third parties. The
company match the inflows and outflows in different currencies caused by
trade, etc., so that it is only necessary to deal on the forex markets for the
unmatched portion of the total transactions.
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between the prices in one market (e.g. New York) and another (e.g. London).
5.7.2 Banks dealing in foreign currency quote two prices for an exchange rate:
(a) a lower bid price
(b) a higher offer/ask price.
For example, a dealer might quote a price for US$/£ of 1.4325 – 1.4330.
⚫ The lower rate, 1.4325, is the rate at which the dealer will sell the
variable currency (US$) in exchange for the base currency (sterling).
⚫ The higher rate, 1.4330, is the rate at which the dealer will buy the
variable currency (US$) in exchange for the base currency (sterling).
5.7.3 Example 4
Suppose that the US$ rate per £ is quoted as 1.4325 – 1.4330.
If the company wants to buy $100,000 in exchange for sterling (so that the
bank will be selling dollars):
⚫ If we used the lower rate of 1.4325, the bank would sell them for
£69,808.
⚫ If we used the higher rate of 1.4330, the bank would sell them for
£69,784.
Clearly the bank would be better off selling them at the lower rate.
If a company wants to sell $200,000 in exchange for sterling (so the bank
would be buy dollars):
⚫ If we used the lower rate of 1.4325, the bank would buy them for
£139,616.
⚫ If we used the higher rate of 1.4330, the bank would buy them for
£139,567.
The bank will make more money buy at the higher rate.
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5.8 Forward exchange hedging (對沖)
(Pilot, Dec 07, Dec 08, Dec 09, Jun 11, Jun 12, Jun 13)
5.8.1 The spot market (現貨市場) is where you can buy and sell a currency now
5.8.2 The forward market (遠期市場) is where you can buy and sell a currency, at
a fixed future date for a predetermined rate, i.e. the forward rate of exchange.
It enters into a forward contract to sell this amount on the forward date at a
rate of $1.60/£. On 30 April the company is guaranteed £6.25 million.
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The risk has been completely removed.
Solution:
Advantages Disadvantages
⚫ Flexibility with regard to the ⚫ Contractual commitment that
amount to be covered. must be completed on the due
⚫ Relatively straightforward both date.
to comprehend and to organize. ⚫ No opportunity to benefit from
favourable movements in
exchange rates.
5.9.2 Suppose a British company needs to pay a Swiss creditor in Swiss francs in
three months time. It does not have enough cash to pay now, but will have
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sufficient in three months time. Instead of negotiating a forward contract, the
company could:
5.9.3 Example 6
A UK company owes a Danish creditor Kr3,500,000 in three months time.
The spot exchange rate is Kr/£ 7.5509 – 7.5548. The company can borrow
in Sterling for 3 months at 8.60% per annum and can deposit kroners for 3
months at 10% per annum. What is the cost in pounds with a money market
hedge and what effective forward rate would this represent?
Solution:
The interest rates for 3 months are 2.15% to borrow in pounds and 2.5% to
deposit in kroners. The company needs to deposit enough kroners now so
that the total including interest will be Kr3,500,000 in three months’ time.
This means depositing:
These kroners will cost £452,215 (spot rate 7.5509). The company must
borrow this amount and, with three months interest of 2.15%, will have to
repay:
Thus, in three months, the Danish creditor will be paid out of the Danish
bank account and the company will effectively be paying £461,938 to
satisfy this debt. The effective forward rate which the company has
manufactured is 3,500,000/461,938 = 7.5768. This effective forward rate
shows the kroner at a discount to the pound because the kroner interest
rate is higher than the sterling rate.
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£ Convert Kr
7.5509
Now: Borrow Deposit
£452,215 Kr3,414,634
Interest Interest
paid: 2.15% earned: 2.5%
5.9.4 A similar technique can be used to cover a foreign currency receipt from a
debtor. To manufacture a forward exchange rate, follow the steps below.
Step 1: Borrow the appropriate amount in foreign currency today
Step 2: Convert it immediately to home currency
Step 3: Place it on deposit in the home currency
Step 4: When the debtor’s cash is received:
(a) Repay the foreign currency loan
(b) Take the cash from the home currency deposit account
5.9.5 Example 7
A UK company is owed SFr 2,500,000 in three months time by a Swiss
company. The spot exchange rate is SFr/£ 2.2498 – 2.2510. The company
can deposit in Sterling for 3 months at 8.00% per annum and can borrow
Swiss Francs for 3 months at 7.00% per annum. What is the receipt in
pounds with a money market hedge and what effective forward rate would
this represent?
Solution:
The interest rates for 3 months are 2.00% to deposit in pounds and 1.75% to
borrow in Swiss francs. The company needs to borrow SFr2,500,000/1.0175
= SFr2,457,003 today. These Swiss francs will be converted to £ at
2,457,003/2.2510 = £1,091,516. The company must deposit this amount
and, with three months interest of 2.00%, will have earned
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£1,091,516 x (1 + 0.02) = £1,113,346
Thus, in three months, the loan will be paid out of the proceeds from the
debtor and the company will receive £1,113,346. The effective forward rate
which the company has manufactured is 2,500,000/1,113,346 = 2.2455.
This effective forward rate shows the Swiss franc at a premium to the
pound because the Swiss franc interest rate is lower than the sterling rate.
S Fr Convert £
2.251
Now: Borrow Deposit
SFr2,457,003 £1,091,516
Interest Interest
paid: 1.75% earned: 2.0%
5.10.1 The choice between forward and money markets is generally made on the
basis of which method is cheaper, with other factors being of limited
significance.
5.10.2 When a company expects to receive or pay a sum of foreign currency in the
next few months, it can choose between using the forward exchange market
and the money market to hedge against the foreign exchange risk. Other
methods may also be possible, such as making lead payments. The cheapest
method available is the one that ought to be chosen.
5.10.3 Example 8
ABC Co has bought goods from a US supplier, and must pay $4,000,000 for
them in three months time. The company’s finance director wishes to hedge
against the foreign exchange risk, and the three methods which the
company usually considers are:
(a) Using forward exchange contracts
(b) Using money market borrowing or lending
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(c) Making lead payments
The following annual interest rates and exchange rates are currently
available.
US dollar Sterling
Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 7 10.25 10.75 14.00
3 months 7 10.75 11.00 14.25
Which is the cheapest method for ABC Co? Ignore commission costs (the
bank charges for arranging a forward contract or a loan).
Solution:
The cost of the $4,000,000 to ABC Co in three months time will be:
$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that
by deferring payment for three months, we assume that the company needs
to borrow the money for the payment.
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At an annual interest rate of 14.25% the rate for three months is 14.25/4 =
3.5625%. The present cost of £2,168,609.38 in three months time is:
It would lend enough US dollars for three months, so that the principal
repaid in three months time plus interest will amount to the payment due of
$4,000,000.
(a) Since the US dollar deposit rate is 7%, the rate for three months is
approximately 7/4 = 1.75%.
(b) To earn $4,000,000 in three months time at 1.75% interest, ABC Co
would have to lend now:
$4,000,000
= $3,931,203.93
1.0175
These dollars would have to be purchased now at the spot rate of $1.8625.
The cost would be:
$3,931,203.93
= £2,110,713,52
1.8625
By lending US dollars for three months, ABC Co is matching eventual
receipts and payments in US dollars, and so has hedged against foreign
exchange risk.
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Summary
£
Forward exchange contract (cheapest) 2,094,010.26
Currency lending 2,110,713.52
Lead payment 2,147,651.01
6.1.2 Example 9
A US company buys goods worth €720,000 from a German company
payable in 30 days. The US company wants to hedge against the €
strengthening against the dollar.
Current spot is 0.9215 – 0.9221 $/€ and the € futures rate is 0.9245 $/€.
The standard size of a 3 month € futures contract is €125,000.
In 30 days time the spot is 0.9345 – 0.9351 $/€.
Closing futures price will be 0.9367.
Solution:
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4. Tick size – minimum price movement x contract size = 0.0001 x
125,000 = $12.50
5. Closing futures price – we are told it will be 0.9367
6. Hedge outcome
Outcome in futures market
Opening futures price = 0.9245
Closing futures price = 0.9367
Movement in ticks = 122 ticks
Futures profit = 122 x $12.50 x 6 contracts = $9,150
Net outcome
$
Spot market payment (720,000 x 0.9351 $/€ 673,272
Futures market profit (9,150)
664,122
Advantages Disadvantages
(a) Transaction costs should be (a) The contracts cannot be
lower than other hedging tailored to the user’s exact
methods. requirements.
(b) Futures are tradeable on a (b) Hedge inefficiencies are caused
secondary market so there is by having to deal in a whole
pricing transparency. number of contracts and by
(c) The exact date of receipt or basis risk.
payment does not have to be (c) Only a limited number of
known. currencies are the subject of
futures contracts.
(d) Unlike options, they do not
allow a company to take
advantage of favourable
currency movements.
Basis risk – the risk that the futures contract price may move by a different
amount from the price of the underlying currency or commodity.
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6.2 Currency options
(Dec 08, Dec 09)
6.2.1 Currency Options
A currency option is a right of an option holder to buy (call) or sell (put)
foreign currency at a specific exchange rate at a future date.
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(b) Let it lapse if:
(i) the spot rate is more favourable
(ii) there is no longer a need to exchange currency.
6.3.2 Example 10
Consider a UK company X with a subsidiary Y in France which owns
vineyards. Assume a spot rate of £1 = 1.6 Euros. Suppose the parent
company X wishes to raise a loan of 1.6 million Euros for the purpose of
buying another French wine company. At the same time, the French
subsidiary Y wishes to raise £1 million to pay new up-to-date capital
equipment imported from the UK. The UK parent company X could borrow
the £1 million sterling and the French subsidiary Y could borrow the 1.6
million Euros, each effectively borrowing on the other’s behalf. They would
then swap currencies.
£1 million
UK France
Company X Subsidiary Y
€1.6 million
Borrow Borrow
£1 million €1.6 million
Bank Bank
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Examination Style Questions
Question 1
Nedwen Co is a UK-based company which has the following expected transactions.
Borrowing Deposit
One year sterling interest rate: 4.9% 4.6%
One year dollar interest rate 5.4% 5.1%
Required:
(a) Discuss the differences between transaction risk, translation risk and economic
risk. (6 marks)
(b) Explain how inflation rates can be used to forecast exchange rates. (6 marks)
(c) Calculate the expected sterling receipts in one month and in three months using
the forward market. (3 marks)
(d) Calculate the expected sterling receipts in three months using a money-market
hedge and recommend whether a forward market hedge or a money market
hedge should be used. (5 marks)
(e) Discuss how sterling currency futures contracts could be used to hedge the
three-month dollar receipt. (5 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper 2006 Q2)
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Question 2
PKA Co is a European company that sells goods solely within Europe. The
recently-appointed financial manager of PKA Co has been investigating the working
capital management of the company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000
units. Forecast demand to meet production requirements during the next year is
625,000 units. The cost of placing and processing an order is €250, while the cost of
holding a unit in stores is €0·50 per unit per year. Both costs are expected to be
constant during the next year. Orders are received two weeks after being placed with
the supplier. You should assume a 50-week year and that demand is constant
throughout the year.
Assume that it is now 1 December and that PKA Co has no surplus cash at the present
time.
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Required:
(a) Identify the objectives of working capital management and discuss the conflict
that may arise between them. (3 marks)
(b) Calculate the cost of the current ordering policy and determine the saving that
could be made by using the economic order quantity model. (7 marks)
(c) Discuss ways in which PKA Co could improve the management of domestic
accounts receivable. (7 marks)
(d) Evaluate whether a money market hedge, a forward market hedge or a lead
payment should be used to hedge the foreign account payable. (8 marks)
(25 marks)
(ACCA F9 Financial Management December 2007 Q4)
Question 3
Three years ago Boluje Co built a factory in its home country costing $3·2 million. To
finance the construction of the factory, Boluje Co issued peso-denominated bonds in a
foreign country whose currency is the peso. Interest rates at the time in the foreign
country were historically low. The foreign bond issue raised 16 million pesos and the
exchange rate at the time was 5·00 pesos/$.
Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end
of each year of 6·1%. The bonds will be redeemed in five years’ time at par. The
current cost of debt of peso-denominated bonds of similar risk is 7%.
In addition to domestic sales, Boluje Co exports goods to the foreign country and
receives payment for export sales in pesos. Approximately 40% of production is
exported to the foreign country.
The spot exchange rate is 6·00 pesos/$ and the 12-month forward exchange rate is
6·07 pesos/$. Boluje Co can borrow money on a short-term basis at 4% per year in its
home currency and it can deposit money at 5% per year in the foreign country where
the foreign bonds were issued. Taxation may be ignored in all calculation parts of this
question.
Required:
(a) Briefly explain the reasons why a company may choose to finance a new
investment by an issue of debt finance. (7 marks)
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(b) Calculate the current total market value (in pesos) of the foreign bonds used to
finance the building of the new factory. (4 marks)
(c) Assume that Boluje Co has no surplus cash at the present time:
(i) Explain and illustrate how a money market hedge could protect Boluje Co
against exchange rate risk in relation to the dollar cost of the interest
payment to be made in one year’s time on its foreign bonds. (4 marks)
(ii) Compare the relative costs of a money market hedge and a forward market
hedge. (2 marks)
(d) Describe other methods, including derivatives, that Boluje Co could use to
hedge against exchange rate risk. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2008 Q4)
Question 4
NG Co has exported products to Europe for several years and has an established
market presence there. It now plans to increase its market share through investing in a
storage, packing and distribution network. The investment will cost €13 million and is
to be financed by equal amounts of equity and debt. The return in euros before interest
and taxation on the total amount invested is forecast to be 20% per year.
The debt finance will be provided by a €6·5 million bond issue on a large European
stock market. The interest rate on the bond issue is 8% per year, with interest being
payable in euros on a six-monthly basis.
The equity finance will be raised in dollars by a rights issue in the home country of
NG Co. Issue costs for the rights issue will be $312,000. The rights issue price will be
at a 17% discount to the current share price. The current share price of NG Co is
$4·00 per share and the market capitalisation of the company is $100 million.
NG Co pays taxation in its home country at a rate of 30% per year. The currency of its
home country is the dollar. The current price/earnings ratio of the company, which is
not expected to change as a result of the proposed investment, is 10 times.
The spot exchange rate is 1·3000 €/$. All European customers pay on a credit basis in
euros.
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Required:
(a) Calculate the theoretical ex rights price per share after the rights issue.
(4 marks)
(b) Evaluate the effect of the European investment on:
(i) the earnings per share of NG Co; and
(ii) the wealth of the shareholders of NG Co.
Assume that the current spot rate and earnings from existing operations are both
constant. (9 marks)
(c) Explain the difference between transaction risk and translation risk, illustrating
your answer using the information provided. (4 marks)
(d) The six-month forward rate is 1·2876 €/$ and the twelve-month forward rate is
1·2752 €/$. NG Co can earn 2·8% per year on short-term euro deposits and can
borrow short-term in dollars at 5·3% per year.
Identify and briefly discuss exchange rate hedging methods that could be used
by NG Co. Provide calculations that illustrate TWO of the hedging methods that
you have identified. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2009 Q3)
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