Slide 1 of x

Example

Foreign Exchange

Problems

Fall 2015

2

Transaction 1 – SheepskinsPURCHASE

• FUZZY SHOES of USA purchases sheepskins from Australia.

• FUZZY SHOES will pay AUS$ 25,000,000 in 90 days.• Present spot exchange rate is US$ 0.7300/AUS$. • 90-day forward contract exchange rate is US$

0.7304/AUS$. • Annual prime lending rate in Australia is 2.00% per

annum. • Annual deposit rate in Australia is 1.50% per annum. • FUZZY SHOES’s cost of capital is 9.00% per annum.

3

What could happen?

• Value of purchase transaction today in US$

AUS$ 25,000,000 X US$ 0.7300/AUS$

= US$ 18,250,000• Depreciation of US$ example

AUS$ 25,000,000 X US$ 0.7357/AUS$

= US$ 18,392,500• Appreciation of US$ example

AUS$ 25,000,000 X US$ 0.7289/AUS$

= US$ 18,222,500

Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

4

90 Day Forward Contract

AUS$ 25,000,000 X US$ 0.7304/AUS$ = US$ 18,260,000 paid in 90 days

Need Present Value (PV) of this payment, must discount by FUZZY SHOES’s cost of capital

PV = Forward Value = US$ 18,260,000 = US$ 17,858,190

(1+ cost of capital ) (1 + .09 )

fraction of year 4

5

Asset – Liability HedgingFUZZY SHOES has an Accounts Payable of AUS$ 25,000,000, a Liability, and needs to match with an Asset, a 90 day bank deposit in Australia. The logic is that after 90 days, the bank deposit’s principal and interest will pay off the Accounts Payable.

The amount to deposit in Australia:

Amount for deposit = Value of Accounts Payable

(1 + deposit rate )

fraction of year

= AUS$ 25,000,000 = AUS$ 24,906,600

(1 + .0150 ) 4

Amount of US$ required for the AUS$ 24,875,6221 bank deposit:

AUS$ 24,906,600 X US$ 0.7300/AUS$ = US$ 18,181,818

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Which to choose?

• PV of 90 day Forward Contract = US$ 17,858,190

• Asset-Liability Hedging = US$ 18,181,818

• Choose 90 day Forward Contract – Pay less US$ 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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Transaction 2 – Shoe SALE

• FUZZY SHOES sells sheepskin shoes in the United Kingdom (UK)

• Will receive payment of UK£ 10,500,000 in 180 days. • The spot exchange rate is US$ 1.5477/ UK£. • 180-day forward contract exchange rate is US$ 1.5485/

UK£. • Annual prime lending rate in the UK is .50% per annum. • Annual bank deposit rate in the UK is .35% per annum.• FUZZY SHOES’s cost of capital is 9.00% per annum.

8

What could happen?

• Value of sales transaction today in US$

UK£ 10,500,000 X US$ 1.5477/ UK£

= US$ 16,250,850• Depreciation of US$

UK£ 10,500,000 X US$ 1.5504/UK£

= US$ 16,279,200• Appreciation of US$

UK£ 10,500,000 X US$ 1.5289/UK£

= US$ 16,053,450

Don’t know what will happen – leads to actions to prevent foreign exchange rate risk

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180 Day Forward Contract

UK£ 10,500,000 X US$ 1.5485/ UK£=

US$ 16,256,100 received in 180 days

Need Present Value (PV) of this sale, must discount by FUZZY SHOES’s cost of capital

PV = Forward Value = US$ 16,256,100 = US$ 15,556,076

(1+ cost of capital ) (1 + .09 )

fraction of year 2

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Asset – Liability Hedging

FUZZY SHOES has an Accounts Receivable of UK£ 10,500,000, an Asset, and needs to match with a Liability, a 180 day loan in the UK. The logic is that after 180 days, the received payment will be sufficient to pay off the 180 bank loan principal plus interest.

The amount to borrow in UK:

Amount to Borrow = Value of Accounts Receivable

(1 + borrowing rate)

fraction of year

Amount to Borrow = UK£ 10,500,000 = UK£ 10,243,902

(1 + .050 )

2

Amount of US$ received from the UK£ 10,243,902 bank loan:

Multiple today’s spot rate US$ 1.5477/ UK£ X UK£ 10,243,902 = US$ 15,854,487

11

Which to choose?

• PV Forward Contract = US$ 15,556,076

• Asset-Liability Hedging = US$ 15,854,487

• Choose Asset-Liability Hedging – Receive more US$ 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