Page 1 of 10

CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE

ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. How would you define transaction exposure? How is it different from economic exposure?

Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s
contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates.
Unlike economic exposure, transaction exposure is well-defined and short-term.

2. Discuss and compare hedging transaction exposure using the forward contract vs. money market
instruments. When do the alternative hedging approaches produce the same result?

Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign
currency receivables or payables forward. On the other hand, money market hedge is achieved by
borrowing or lending the present value of foreign currency receivables or payables, thereby creating

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 2 of 10

offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are
equivalent.

3. Discuss and compare the costs of hedging via the forward contract and the options contract.

Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging,
however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging,
however, may be realized ex post when the hedger regrets his/her hedging decision.

4. What are the advantages of a currency options contract as a hedging tool compared with the forward
contract?

Answer: The main advantage of using options contracts for hedging is that the hedger can decide
whether to exercise options upon observing the realized future exchange rate. Options thus provide a
hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the
downside risk while retaining the upside potential.

5. Suppose your company has purchased a put option on the euro to manage exchange exposure
associated with an account receivable denominated in that currency. In this case, your company can be
said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.

Answer: Your company in this case knows in advance that it will receive a certain minimum dollar
amount no matter what might happen to the $/€ exchange rate. Furthermore, if the euro appreciates,
your company will benefit from the rising euro.

6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply
do not hedge. How would you explain this result?

Answer: There can be many possible reasons for this. First, many firms may feel that they are not really
exposed to exchange risk due to product diversification, diversified markets for their products, etc.
Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders
can diversify exchange risk themselves, rendering corporate risk management unnecessary.

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 3 of 10

7. Should a firm hedge? Why or why not?

Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to
their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure
better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to
hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because
it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax
obligations by hedging which stabilizes corporate earnings.

9. Explain contingent exposure and discuss the advantages of using currency options to manage this
type of currency exposure.

Answer: Companies may encounter a situation where they may or may not face currency exposure. In
this situation, companies need options, not obligations, to buy or sell a given amount of foreign
exchange they may or may not receive or have to pay. If companies either hedge using forward
contracts or do not hedge at all, they may face definite currency exposure.

10. Explain cross-hedging and discuss the factors determining its effectiveness.

Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The
effectiveness of cross-hedging would depend on the strength and stability of the relationship between
the two assets.

PROBLEMS

3. You plan to visit Geneva, Switzerland in three months to attend an international business conference.
You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As
of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy
the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF.
Assume that your expected future spot exchange rate is the same as the forward rate. The three-month
interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 4 of 10

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward
contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option market
hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate
under both the options and forward market hedges.

Solution:
(a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 = $250(1.015). At
the expected future spot rate of $0.63/SF, which is less than the exercise price, you don’t expect to
exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy SF5,000,
you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the
sum of $3,150 and $253.75, i.e., $3,403.75.

(b) $3,150 = (.63)(5,000).

(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we
obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.

(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will
exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 =
$3,200 + $253.75. This is the maximum you will pay for SF5,000.

$ Cost

$3,453.75 Options hedge

$3,150 Forward hedge

$253.75
$/SF
0 0.579 0.64
(strike price)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 5 of 10

6. Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy
Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year
forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can
also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 US$
cents per yen (in other words 0.014/100). (see it as a basis point of 0.014/100)
(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the
forward hedges.
(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the
expected future dollar cost of meeting this obligation when the option hedge is used.
(c) At what future spot rate do you think PCC may be indifferent between the option and forward
hedge?

Solution:
(a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of
money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)
= $4,147,465.

(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) =
$75,600.
At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will
exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).
The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.

(c) When the option hedge is used, PCC will spend “at most” $4,125,600. On the other hand, when the
forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means
that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between
forward and options hedges.

7. Consider a U.S.-based company that exports goods to Switzerland. The U.S. Company expects to
receive payment on a shipment of goods in three months. Because the payment will be in Swiss francs,
the U.S. Company wants to hedge against a decline in the value of the Swiss franc over the next three

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 6 of 10

months. The U.S. risk-free rate is 2 percent, and the Swiss risk-free rate is 5 percent. Assume that
interest rates are expected to remain fixed over the next six months. The current spot rate is $0.5974
a. Indicate whether the U.S. Company should use a long or short forward contract to hedge currency
risk.
b. Calculate the no-arbitrage price at which the U.S. Company could enter into a forward contract that
expires in three months.
c. It is now 30 days since the U.S. Company entered into the forward contract. The spot rate is $0.55.
Interest rates are the same as before. Calculate the value of the U.S. Company’s forward position.

Solution:
a. The risk to the U.S. company is that the value of the Swiss franc will decline and it will receive fewer
U.S. dollars on conversion. To hedge this risk, the company should enter into a contract to sell Swiss
francs forward.

b. S0 = $0.5974
T = 90/365
r = 0.02
rf = 0.05

F (0, T )  Sx{[(1  r ) T ] /[1x(1  r f ) T ]}

Where rf = foreign currency interest rate (base currency); T = period of time e.g. 30days/365 days

Understanding this formula.: In previous chapters we used simple interest rates to calculate forward
exchange rate (for example: 12% per annum interest rate for a six month forward = 12/2 =
(1+0.06%). The formula here just use the effective annual interest rate compounding methodology
(for example: 12% per annum interest rate for six month forward = (1+0.12) 180/365. Therefore answers
will differ slightly from just applying simple interest rate.

F (0, T )  0.5974 x{[(1.02) 90 / 365 ] /[1x(1.0590 / 365 ]}  $0.5931 , therefore

Forward rate: = $0.5974 x (1.02)90/365/(1.05)90/365 = $0.593145 or

 .5974 
F (0, T )   90 / 365 
(1.  0.02) 90 / 365  $0.593145 = ~$0.5931
 (1  0 .05) 

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 7 of 10

c. St = $0.55
T = 90/365
t = 30/365
T – t = 60/365
r = 0.02
rf = 0.05
Formula:

St F (0, T )
Vt (0, T )  
(1  r f ) (T t ) (1  r ) (T t )
Where rf = foreign currency interest rate; T-t = period of time e.g 90days/365 days where T = total
period of forward and t = time of period already passed e.g . 30/365 days

Understanding why we use this formula:

The quote is USD/SF.  In this case SF is the base currency and USD is the quote currency.

The U.S Company is short on SF 3 month (90 days) forward at $ 0.5931.  Spot is $0.5500 and the US
interest rate is 2% and SF interest rate is 5%.

Now let’s mark it to market – 30 days later.

In this case if the company conducts the forward transaction in 60 days, it would receive $0.593145 for
every SF that it sells based on the forward contract exchange rate

Therefore here are the cash flows:

Pay 1 SF

Receive $0.593145 =~$ 0.5931

In order to mark this to market, what the company needs to do is: find the expected future cash flow
payoff in 60 days, to take an offsetting position, and then discount this payoff until today.

So, if the company is going to take a position at current market rates to offset this forward exactly, it has
to go long in SF at the prevailing forward rate (the forward rate that can be calculated at today’s spot
exchange rate and the interest rates prevailing today).

So first the prevailing forward rate has to be calculated:

Spot * (1+US Rate)60/365 / (1+SF rate)60/365 = $0.5500*{[(1+.0260/365]/[(1+.05)60/365]} = $0.547385 = ~$0.5474

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 8 of 10

So in order to lock in the position, the company needs to buy SF forward for 60 days at $0.5474.

When this is done the new portfolio cash flows in 60 days will be:

Original 90 day forward: Pay 1 SF

Receive$0.593145 =~$0.5931

New closing out position for 60 day forward contract: Receive 1SF

Pay$0.5474385 ~$0.5474

So as you can see, the company is net 0 (zero) in SF (-1+1)

But the company is positive in $, namely $0.0457596 = (+0.593145 – 0.5474385 )

So from these two transactions, the company locked in a cash inflow of $0.0457596 = ~$0.0458 60 days
from now.

Obviously time value of money prevails here and as the company will receive this $ cash flow only after
60 days. The company can discount the profit at the same rate as the cash flow currency, which is $,
with and interest rate of 2% for 60 days considering the time value of it.

$0.0457596 / (1+.02)60/365 = $0.0456109 =~$0.0456

This is the current value of the forward contract.

By applying the formula we get to the same answer:

St F (0, T )
Vt (0, T )  f ( T t )

(1  r ) (1  r ) (T t )
$0.55 $0.5931
 60 / 365

(1.05) (1.02) 60 / 365
 .5456  .5912
 $0.0456

The PV of the spot price exchange rate shows a higher value for the $ to the SF with the discounted
spot rate than with the discounted forward rate. This represents a gain to the short position of
$0.0456 per Swiss franc. In this problem, the U.S. company holds the short forward position. If it was
a long position, it would have been a loss of $0.0456.

8. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect the value
of the pound to increase against the U.S. dollar over the next 30 days. You will be making payment on a
shipment of imported goods in 30 days and want to hedge your currency exposure. The U.S. risk-free
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 9 of 10

rate is 5.5 percent, and the U.K. risk-free rate is 4.5 percent. These rates are expected to remain
unchanged over the next month. The current spot rate is $1.50.
a. Indicate whether you should use a long or short forward contract to hedge currency risk.
b. Calculate the no-arbitrage price at which you could enter into a forward contract that expires in 30
days.
c. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the value of
your forward position.

Solution:
a. The risk to you is that the value of the British pound will rise over the next 30 days and it will require
more U.S. dollars to buy the necessary pounds to make payment. To hedge this risk, you should enter
a forward contract to buy British pounds.

b. S0 = $1.50
T = 30/365
r = 0.055
rf = 0.045
F (0, T )  1.5000x{[(1.05530 / 365 ] /[1x(1.04530 / 365 ]}  $1.5012

or

 $1.5000 
F (0, T )   30 / 365 
(1.055) 30 / 365  $1.5012
 (1.045) 

c. St = $1.53
T = 30/365
t = 10/365
T – t = 20/365
r = 0.055
rf = 0.045

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
 Page 10 of 10

$1.5300 $1.5012
Vt (0, T )  20 / 365
  $0.0295
(1.045) (1.055) 20 / 365

Because you are long, this is a gain of $0.0295 per British pound.

d. Not applicable - students are not required to do this part of the question.

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.