Problem 8.

2 Hindustan Lever
Unilevers affiliate in India, Hindustan Lever, procures much of its toiletries product line from a Japanese company. Because of the shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. Hindustan Lever wishes to hedge a 8.5 million Japanese yen payable. Although options are not available on the Indian rupee (Rs), forward rates are available against the yen. Additionally, a common practice in India is for companies like Hindustan Lever to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy. Assumptions 180-day account payable, Japanese yen () Spot rate (/$) Spot rate, rupees/dollar (Rs/$) Implied (calculated) spot rate (/Rs) 180-day forward rate (/Rs) Expected spot rate in 180 days (/Rs) 180-day Indian rupee investing rate 180-day Japanese yen investing rate Currency agent's exchange rate fee Hindustan Lever's cost of capital Hedging Alternatives 1. Remain Uncovered, settling A/P in 180 days at spot rate If spot rate in 180 days is same as current spot If spot rate in 180 days is same as forward rate If spot rate in 180 days is expected spot rate 2. Buy Japanese yen forward 180 days Settlement amount at forward rate (Rs) 3. Money Market Hedge Principal A/P () discount factor for yen investing rate for 180 days Principal needed to meet A/P in 180 days () Current spot rate (/Rs) Indian rupee, current amount (Rs) Hindustan Lever's WACC carry-forwad factor for 180 days Future value of money market hedge (Rs) 4. Indian Currency Agent Hedge Principal A/P () Current spot rate (/Rs) Current A/P (Rs) Plus agent's fee (4.850%) Hindustan's WACC carry-forwad factor for 180 days on fee Total future value of agent's fee (Rs) Total A/P, future value, A/P + fee (Rs) Evaluation of Alternatives The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives. 8,500,000.00 2.5257 3,365,464.34 163,225.02 1.0600 173,018.52 3,538,482.87 Certain 8,500,000.00 0.9926 8,436,724.57 2.5257 3,340,411.26 1.0600 3,540,835.94 3,541,666.67 2.4000 Certain 3,365,464.34 3,541,666.67 3,269,230.77 2.5257 2.4000 2.6000 Risky Risky Risky Values 8,500,000 120.60 47.75 2.5257 2.4000 2.6000 8.000% 1.500% 4.850% 12.00% Values

(120.60 / 47.75)

Spot Rate (Rp/$)

Risk Assessment

Certain

Problem 8.3 Warner Indonesia

Warner, the U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterolreduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450/$, translates into nearly $175,000. Although not a big sale by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in this case, a cash settleemnt of $168,000. The current 90-day forward rate is Rp9,950/$. Although this rate appeared unattractive, Warner had to contact several major banks before even finding a forward quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly falling to Rp9,400/$ over the coming 90 to 120 days. Analyze the prospective sale and make a hedging recommendation. Assumptions Receivable due in 3 months, in Indonesian rupiah (Rp) Spot rate (Rp/$) Expected spot rate in 90 days (Rp/$) 3-month forward rate (Rp/$) Minimum dollar amount acceptable at settlement Values Rp1,650,000,000 9,450 9,400 9,950 $168,000.00 At Spot $174,603.17

Alternatives 1. Remain Uncovered. Settle A/R in 90 days at current spot rate. If spot rate in 90 days is same as current (Rp750,000,000 / Rp8,800/$) If spot rate in 90 days is Rp9,400/$ (Rp750,000,000 / Rp9,400/$) If spot rate in 90 days is Rp9,800/$ (Rp750,000,000 / Rp9,800/$)

Values

Risk Assessment

$174,603.17

Risky

$175,531.91

Risky

$165,829.15

Risky

2. Sell Indonesian rupiah forward. A/R sold forward 90 days "Cost of cover" is the forward discount on Rp Analysis The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level. Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets. In the end, Pfizer will have to decide whether making the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using forward cover. $165,829.15 -20.1% Certain

Problem 8.4 Embraer of Brazil

Embraer of Brazil is one of the two leading global manufacturers of regional jets (Bombardier of Canada is the other). Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100 people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one year from now for $80 million. Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs it must pay foreign suppliers $20 million for inputs one year from now (but they will be delivering the sub-components throughout the year). The current spot rate on the Brazilian real (R$) is R$2.420/$, but it has been steadily appreciating against the U.S. dollar over the past year, from a peak of R$3.200/$ only a year ago. Forward contracts are difficult to acquire and considered expensive. Citibank Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the current 4.00% U.S. dollar eurocurrency rate and the 14.00% Brazilian government deposit note. Assumptions Receivable due in one year, US dollars Payable due in one year, US dollars Spot rate, R$/$ One-year US dollar eurocurrency interest rate One-year Brazilian govt deposit note Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) Values $80,000,000 $20,000,000 2.4200 4.00% 14.00% 2.6527 Risk Assessment

Analysis Net exposure at time of cash settlements: One year A/R due One year A/P due Net exposure

Values

$80,000,000 ($20,000,000) $60,000,000

Certain

This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian real, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a very good thing.

Cash settlement of the net position: Brazilian reais in one year at current spot rate Brazilian reais in one year at one year forward rate R$ 145,200,000.00 R$ 159,161,538.46 Risky Certain

In this case, however, because the real is selling forward at a considerable discount, the net long position -- if sold forward -yields considerably more real than the current spot rate. It should also be noted, however, that if the real were to fall considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.

Problem 8.5 Mattel Toys

Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, 30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattels treasury team has collected the following currency and market quotes. The companys foreign exchange advisors believe the euro will be at about $1.1800/ in 90 days. Mattels management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable. Assumptions 90-day A/R () Current spot rate (4/) Credit Suisse 90-day forward rate ($/) Barclays 90-day forward rate ($/) Expected spot rate in 90 days ($/) 90-day eurodollar interest rate 90-day euro-euro interest rate Implied 90-day forward rate (calculated, $/) 90-day eurodollar borrowing rate 90-day euro-euro borrowing rate Mattel Toys weighted average cost of capital ($) Values 30,000,000.00 $1.2186 $1.2170 $1.2210 $1.1800 4.000% 4.400% $1.2174 5.000% 5.500% 9.600% Risk Assessment

Hedging Alternatives 1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current If spot rate in 90 days is same as Credit Suisse forward rate If spot rate in 90 days is same as Barclays forward rate If spot rate in 90 days is expected spot rate 2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate Settlement amount at Barclays forward rate 3. Money Market Hedge Principal A/R in euros discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R Current spot rate, $/euro US dollar current value Mattel's WACC carry-forward factor for 90 days Future value of money market hedge Evaluation of Alternatives

Values

$36,558,000.00 $36,510,000.00 $36,630,000.00 $35,400,000.00

Risky Risky Risky Risky

$36,510,000.00 $36,630,000.00

Certain Certain

30,000,000.00 0.9864 29,593,094.94 $1.2186 $36,062,145.50 1.0240 $36,927,636.99

1/(1 + (.055 x 90/360))

1 + (.0960 x 90/360) Certain

The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).

Problem 8.16 Aqua-Pure

Aqua-Pure is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 20th the company sold a system to the City of Nagasaki, Japan, for installation in Nagasakis famous Glover Gardens (where Puccinis Madame Butterfly waited for the return of Lt. Pinkerton.) The sale was priced in yen at 20,000,000, with payment due in three months. Additional information: Aqua-Pures Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese money rate. Aqua-Pure's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable. a) What are the costs and benefits of alternative hedges? Which would you recommend, and why? b) What is the breakeven reinvestment rate when comparing forward and money market alternatives? Assumptions Amount of receivable, Japanese yen () Spot exchange rate at time of sale (/$) Booked value of sale (amount/spot rate) Days receivable due Aqua-Pure's WACC Competitor borrowing premium, yen () Forward rates and premiums One-month forward rate (/$) Three-month forward rate (/$) One-year forward rate (/$) Investment rates, % per annum 1 month 3 months 12 months Purchased options 3-month call option on yen 3-month put option on yen a. Alternative Hedges 1. Remain uncovered. Account receivable (yen) Possible spot rate in 90 days (yen/$) Cash settlement in 90 days (US$) 2. Forward market hedge. Account receivable (yen) Forward rate (won/$) Cash settlement in 90 days (US$) 3. Money market hedge. Account receivable (yen) Discount factor for 90 days Yen proceeds up front Current spot rate (won/$) US dollars received now Carry forward at Aqua-Pure's WACC Proceeds in 90 days 4. Put option hedge. (Need to sell yen = put on yen) Option principal Current spot rate (won/$) Premium cost of option (%) Option pm (principal/spot rate x % pm) If option exercised, dollar proceeds Less Pm carried forward 90 days Net proceeds in 90 days 20,000,000 1.00523 19,895,858 118.255 $168,245.38 1.0400 $174,975.20 1 + ((.0009375 + .02) x 90/360) 20,000,000 116.830 $171,188.91 20,000,000 118.255 $169,126.04 Values 20,000,000 118.255 $169,126.04 90 16.0% 2.0% Forward Rate 117.760 116.830 112.450 United States 4.8750% 4.9375% 5.1875% Strike (yen/$) 118.000 118.000 Values Premium 5.04% 4.88% 5.16% Japan 0.09375% 0.09375% 0.31250% Premium 1.0% 3.0% Certainty

Uncertain.

Certain.

1 + (.16 x 90/360) Certain.

20,000,000 118.255 3.000% $5,073.78 $169,491.53 (5,276.732) $164,214.79

1.04 carry-forward rate Minimum.

The put option does not GUARANTEE the company of settling for the booked amount. The money market and forward hedges do; the money market yielding the higher proceeds. b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate: Money market, US$ up-front $168,245.38 Forward contract, US$, end of 90 days $171,188.91 (1 + x) 101.750% $168,245.38 (1+x) = $171,188.91 x 1.74954% For 90 days Breakeven rate, % per annum 6.998%

Problem 8.17 Redwall Pump Company

On March 1st, Redwall Pump Company sold a shipment of pumps to Vollendam Dike Company of the Netherlands for 4,000,000, payable 2,000,000 on June 1st and 2,000,000 on September 1st. Redwall derived its price quote of 4,000,000 on February 1st by dividing its normal U.S. dollar sales price of $4,320,000 by the then current spot rate of $1.0800/. By the time the order was received and booked on March 1st, the euro had strengthened to $1.1000/, so the sale was in fact worth 4,000,000 x $1.1000/ = $4,400,000. Redwall had already gained an extra $80,000 from favorable exchange rate movements! Nevertheless Redwall's director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible:

1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/ and the 6-month forward quote was $1.1130/. 2. Hedge in the money market. Redwall could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum. 3. Hedge with foreign currency options. June put options were available at strike price of $1.1000/ for a premium of 2.0% per contract, and September put options were available at $1.1000/ for a premium of 1.2%. June call options at $1.1000/ could be purchased for a premium of 3.0%, and September call options at $1.1000/ were available at a 2.6% premium. 4. Do nothing. Redwall could wait until the sales proceeds were received in June and September, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market. Assumptions 90-day Forward rate, $/ 180-day Forward rate, $/ US Treasury bill rate Redwall's borrowing rate, euros, per annum Redwall's cost of equity Options on euros June maturity options September maturity options Valuation of Alternative Hedges Amount of receivable, in euros a. Hedge in the forward market Amount of receivable, in euros Respective forward rates ($/) US dollar proceeds as hedged ($) Carry forward to Sept 1st at WACC Total US$ proceeds on Sept 1st Total of both payments b. Hedge in the money market Amount of receivable, in euros Discount factor for euro funds, period Current proceeds from discounting, euros Current spot rate ($/) Current US dollar proceeds Carry forward rate for the period US dollar proceeds on future date Total of both payments c. Hedge with options Amount of receivable, in euros Buy put options for maturities (% x spot value) Carry forward for the period Premium cost carried forward to Sept 1 Gross put option value if exercised Carried forward 3 months to Sept 1 Gross proceeds, Sept 1 Total net proceeds, after premium deduction, Sept 1 d. Do nothing (remain uncovered) Amount of receivable, in euros Ending spot exchange rate ($/) 2,000,000 ??? 2,000,000 ??? 2,000,000 ($44,000) 1.06 ($46,640) $2,200,000 1.03 $2,266,000 $4,391,376 2,000,000 ($26,400) 1.06 ($27,984) $2,200,000 ---$2,200,000 2,000,000 1.02 1,960,784 $1.1000 $2,156,863 1.06 $2,286,275 $4,528,582 2,000,000 1.04 1,923,077 $1.1000 $2,115,385 1.06 $2,242,308 2,000,000 $1.1060 $2,212,000 1.03 $2,278,360 $4,504,360 2,000,000 $1.1130 $2,226,000 ----$2,226,000 Values $1.1060 $1.1130 3.600% 8.000% 12.000% Strike ($/euro) $1.1000 $1.1000 Today is March 1 Date February 1 March 1 Exchange Rate ($/) $1.0800 $1.1000

Call Option 3.0% 2.6% June Receivable 2,000,000

Put Option 2.0% 1.2% Sept Receivable 2,000,000

The money market hedge provides the highest certain outcome. If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.

Problem 8.18 Tek -- Italian account receivable

Tek wishes to hedge a 4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment is due in 3 months. Teks Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank has offered Tek the following quotes: Assumptions Account receivable due in 3 months, in euros () Spot rate ($/) 3-month forward rate ($/) 3-month euro interest rate 3-month put option on euros: Strike rate ($/) Premium, percent per year Tek's weighted average cost of capital Values 4,000,000.00 1.2000 1.2180 4.200% 1.0800 3.400% 9.800% a) Value b) Certainty?

What are the costs and risk of each alternative? 1. Do nothing and exchange euros for dollars at end of 3 months Amount of euro receivable If spot rate in 3 months is the same as the forward rate US dollar proceeds of receivable would be Amount of euro receivable If spot rate in 3 months is the same as the current spot rate US dollar proceeds of receivable would be 2. Sell euro receivable forward at the 3-month forward rate Amount of euro receivable forward rate US dollar proceeds of receivable would be 3. Buy a put option on euros Amount of euro receivable Current spot rate ($/euro) Premium on put option, % Cost of put option (amount x spot rate x percent premium) If the spot rate at end of 3-months is less than strike rate the option is exercised yielding gross dollars of Less cost of option (premium) plus US$ interest on premium Net proceeds of A/R if option is exercised (this is Minimum) Summary of Alternatives Do Nothing Sell A/R forward Buy Put Option c) If Tek wishes to play it safe, it should lock in the forward rate.

4,000,000.00 1.2180 $4,872,000.00 4,000,000.00 1.2000 $4,800,000.00

Very uncertain; Risky

Very uncertain; Risky

4,000,000.00 1.2180 $4,872,000.00

Certain; Locked-in

4,000,000.00 1.2000 3.400% $163,200.00 Minimum is guaranteed; could be greater. Certainty? Risky Certain Minimum

$4,320,000.00 (167,198.40) $4,152,801.60 Value $4,800,000.00 $4,872,000.00 $4,152,801.60

d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3-month period, past $1.20/, then Tek might consider purchasing the put option on euros.

Problem 8.19 Tek -- Japanese account payable

Tek has imported components from its joint venture in Japan, Sony-Tek, with payment of 8,000,000 due in 6 months. Citibank has offered Tek the following quotes Assumptions Account payable to Japan Sony-Tek, in Japanese yen () Spot rate (/$) 6-month forward rate (/$) 6-month yen deposit rate 6-month dollar interest rate 6-month call option on yen: Strike rate (/$) Premium, percent per year Tek's weighted average cost of capital What are the costs and risk of each alternative? 1. Do nothing and exchange dollars for yen at end of 6 months Amount of yen payable If spot rate in 3 months is the same as the forward rate US dollar cost of settling payable would be Amount of yen payable If spot rate in 3 months is the same as the current spot rate US dollar cost of settling payable would be 2. Buy yen forward 6-months to lock in cost of settling payable Amount of yen payable forward rate US dollar cost of settling payable would be 3. Money market hedge -- invest funds in yen deposit now Principal needed at the end of 6-months, yen Discount factor, 6-months @ yen deposit rate Yen deposit needed, now Current spot rate (/$) US dollars needed now, for exchange into yen Carry-forward rate, 6 months @ Tek's WACC US cost of money market hedge at end of 6-months 4. Buy a call option on Japanese yen Amount of yen payable Current spot rate (/$) Premium on call option, % Cost of call option If the spot rate at end of 3-months is greater than strike rate the option is exercised yielding gross dollars of Plus cost of option (premium) plus US$ interest on premium Total cost of exercising call option on yen Summary of Alternatives: Cost of settling A/P Do Nothing Buy yen forward Deposit yen now (money market hedge) Buy call option on yen 8,000,000.00 108.20 2.500% $1,848.43 Maximum cost guaranteed; could be less. Certainty? Risky Certain Certain Maximum 8,000,000 0.9938 7,950,311 108.20 $73,477.92 1.05 $77,078.33 a) Values 8,000,000.00 108.20 106.20 1.250% 4.000% 108.00 2.500% 9.800% Value b) Certainty

8,000,000.00 106.20 $75,329.57 8,000,000.00 108.20 $73,937.15

Very uncertain; Risky

Very uncertain; Risky

8,000,000.00 106.20 $75,329.57

Certain; Locked-in

1/(1 + (.0125 x 180/360))

1 + (.0980 x 180/360)

$74,074.07 1,939.00 $76,013.08 Value $73,937.15 $75,329.57 $77,078.33 $76,013.08

c) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the yen may be depreciating (falling) versus the dollar over the coming 6-month period, somewhere below the option strike rate of 108/$, then Tek might consider purchasing the call option. If Tek is a bit more risk adverse, the forward rate is relatively attractive compared to the money market hedge.

Problem 8.20 Tek -- British Telecom bidding

Tek has made a 1,500,000 bid to supply and install a network monitoring system for British Telecom in Manchester, U.K. The bid is good for 30 days at which time the winner of the bidding process will be announced. Other bidders are expected to be Agilent, Siemens, and at least two British firms. If Tek wins the bid it will have 60 days to build and install the system. During this 90-day period the 1,500,000 will be accounted for as backlog. Upon delivery and testing of the system British Telecom will make full payment 30 days later. During this month Tek will account for the 1,500,000 as an account receivable. Barclays Bank (UK) has offered Tek the following quotes: Assumptions Account receivable of bid, supply & install (British pounds, ) Spot rate ($/) Tek's weighted average cost of capital Values 1,500,000 1.8418 9.800% 1-month 1.8368 4.000% 6.500% 1.85 $0.006 a) Value b) 4-month 1.8268 4.125% 6.500% 1.85 $0.012 Certainty

Forward rate ($/) British pound investment rate British pound borrowing rate Put option on pound: Strike rate ($/) Premium ($/) Analysis and Evaluation If Tek wins the bid, it will be long foreign currency, having a 1.5 million pound position which is first backlog the an A/R. If and when Tek is awarded the bid, it would have 4 months (120 days) until cash settlement of the 1.5 million pound position. 1. Do Nothing -- Remaining Uncovered Wait 120 days and exchange pounds for dollars spot If the ending spot rate is the same as current spot rate If the ending spot rate is the same as the 4-month forward rate It could, however, be much lower. 2. Sell the pounds forward Selling 1 million pounds forward at the 4-month forward rate The primary problem with this is that if Tek does not win the bid, it has a forward contract to sell pounds which it will not earn. 3. Money market hedge -- borrow against expected receipts Expected receipts () Discount factor for 4-months at pound borrowing rate Proceeds from borrowing, now () Current spot rate ($/) Proceeds from borrowing, now ($) Carry-forward rate, 4 months @ Tek's WACC Value in 4 months of money market hedge ($) 4. Buy a put option on pounds at strike price of 1.58 Option, if exercised (if ending spot rate less than $1.85) Put option premium, up-front and the 4-months opportunity cost of premium Total premium expense Minimum dollars received if put option purchased

$2,762,700.00 $2,740,200.00

Risky Risky

$2,740,200.00

Certain Value If Tek Wins Bid

1,500,000 0.9788 1,468,189 1.8418 $2,704,110.93 1.0327 $2,792,445.22

1/(1+(0.065 x 120/360))

1 + (.098 x 120/360)

$2,775,000.00 $18,000.00 588.00 $18,588.00 $2,756,412.00 Minimum; Could be More

The money market hedge provides the largest dollar value at the end of 4 months, but it assumes certainty of bid's award. The advantage of the option is if Tek does not win the bid, the option can easily be sold.

Problem 8.21 Tek -- Swedish price list

Tek offers oscilloscopes and other off-the-shelf products through foreign-currency-denominated price lists. The prices are valid for 3 months only. One example is a Swedish price list expressed in Swedish kronor (SKr). In effect, customers are given a cost-free call option on products with a fixed dollar/krona exchange rate. During a typical 3-month period, Tek could expect to sell SKr 5,000,000 SKr 10,000,000 worth of products based on the price list. Since the SKr/$ exchange rate is likely to change during any 3-month period, Tek would like to hedge this transaction exposure (Teks Swedish business unit does believe the krona will be strengthening versus the dollar in the coming months). Nordea Bank (Sweden) has offered Tek the following quotes: Assumptions Expected sale over 90-day period, Swedish krona (SKr) Spot rate (SKr/$) 90-day forward rate (SKr/$) 3-month dollar interest rate 3-month krona deposit interest rate 3-month krona borrowing interest rate 3-month put option on krona: Strike rate (SKr/$) Premium Tek's weighted average cost of capital Values 5,000,000.00 7.4793 7.4937 4.000% 4.780% 6.500% 7.50 2.500% 9.800%

Could be more

Hedging Alternatives This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of sales will occur, and therefore what Tek's actual long position in Swedish krona will be. Value 1. Do Nothing -- Remain Uncovered. The ending spot rate at the time of settlement could be nearly anything. If the ending spot rate is the same as current spot rate (SKr/$) $668,511.76 If the ending spot rate is the same as forward (SKr/$) 2. Sell Swedish krona forward Sold forward 3-months at forward rate (SKr/$) However, remember that Tek does not know total sales. 3. Money market hedge Tek would borrow now against expected proceeds of (SKr) Discount rate of SKr interest rate for 90-days SKr proceeds from borrowing received up-front Exchanged at current spot rate (SKr/$) US dollars received now Tek carry-forward rate for US$ for 90 days Money market hedge proceeds in 90-days 4. Buy a 3-month put option on Swedish krona Proceeds will be option less premium if exercised (minimum) Exchange rate if exercised/not exercised (SKr/$) Amount of Swedish krona If exercised, it will yield a gross dollar amount of Put option premium Opportunity cost of premium Total future value of premium Minimum net dollar proceeds at end of 90 days (exercised gross amount less future value of premium) $667,227.14 $667,227.14

Certainty?

Risky Risky

Certain

5,000,000.00 0.98401 4,920,049.20 7.48 $657,822.15 1.025 $673,938.79 If exercised 7.50 5,000,000.00 $666,666.67 $16,712.79 409.46 $17,122.26 $649,544.41 Minimum If not exercised (random choice) 7.24 5,000,000.00 $690,607.73 $16,712.79 409.46 $17,122.26 $673,485.48

The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in relative value arising from carrying-forward the dollars at Tek's WACC.)

If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to about SKr7.24 (shown above) in order for the put option to yield roughly the same amount of US dollars as the money market hedge.

Problem 8.22 Tek -- Swiss dividend payable

Teks European subsidiaries are formally owned by a holding company, Tek-Switzerland. Thus, the subsidiaries pay dividends to the Swiss holding company, which in turn pays dividends to Tek-Beaverton. Tek has declared a dividend of 5 million Swiss francs payable in 3 months from Switzerland to Tek-Beaverton. If Tek-Beaverton wishes to hedge this transaction exposure it could utilize the following quotes from Swiss Bank Corporation: What are the costs of each alternative for hedging the dividend payable? What are the risks of each alternative? Which alternative should Tek choose? Explain your assumption about Teks motivation in choosing your suggested alternative. Assumptions Dividend declared, Swiss francs (SFr) Spot rate (SFr/$) 90-day forward rate (SFr/$) 3-month US dollar interest rate 3-month Swiss franc interest rate 3-month put option on Swiss francs: Strike rate (SFr/$) Premium ($/SFr) Tek's weighted average cost of capital Tek's expected spot rate in 90 days (SFr/$) Hedging Alternatives 1. Do Nothing -- Remain Uncovered. If the ending spot rate is the same as current spot rate (SFr/$) If the ending spot rate is the same as forward (SKr/$) Realistically, the ending spot rate could vary between SFr1 and SFr2 per $. 2. Sell Swiss francs forward Sold forward 3-months at forward rate (SFr/$) 3. Money Market Hedge Borrow SFr now against future receipt Principal Borrow SFr at SFr interest rate for 90-days SFr proceeds received now via borrowing Exchanged into US$ at spot rate of (SFr/$) Dollars received now Carry-forward rate for US$ at Tek's WACC for 90-days Money Market Hedged proceeds in 90 days 4. Buy a 3-month put option on Swiss francs Proceeds = option - premium, if exercised (minimum) Effective exchange rate if exercised/not exercised, SFr/$ Principal of payment, SFr If exercised, it will yield a gross dollar amount of Put option premium Opportunity cost of premium Total future value of premium Minimum net dollar proceeds at end of 90 days (exercised gross amount less future value of premium) SFr. 5,000,000 0.9907 SFr. 4,953,560 1.25 $3,974,932.09 1.0245 $4,072,317.93 If exercised If not exercised $4,022,849.79 Certain $4,012,197.08 $4,022,849.79 Risky Risky Values SFr. 5,000,000 1.2462 1.2429 4.000% 3.750% 1.25 $0.015 9.80% 1.22 Value Certainty?

1.25 SFr. 5,000,000 $4,000,000.00 $75,000.00 1,837.50 $76,837.50 $3,923,162.50 Minimum

1.22 SFr. 5,000,000 $4,098,360.66 $75,000.00 1,837.50 $76,837.50 $4,021,523.16

Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some degree of currency risk, and believes in the direciton of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.22/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.20/$ or stronger to end up superior to the Money Market Hedge.)