Question 1. A U.S. firm wishes to hedge Canadian dollar receivables. The firm can enter a forward contract to sell 100,000 Canadian dollars in one year at a rate of F12(US$/C$)=0.80. One year from now, the spot price of the Canadian dollar is 0.83.
A) Calculate the U.S. dollars received by the firm (i) if the receivables are hedged with a forward contract and (ii) if they are not hedged.
B) If the firm is comparing the forward contract to being unhedged, what are some reasons why it might choose the forward contract?
C) The firm also finds out that it can buy a put option on the Canadian dollar with a one-year maturity for a strike price of $0.82 at a cost of US$0.02 per Canadian dollar.
i) What is the cost of purchasing the put option (contract cost only)?
ii) How many U.S. dollars will the firm have in one year if it purchases and exercises the put option?
iii) Suppose the firm buys the put option. Does it exercise this option? Why or why not?
iv) Without knowing what the future spot rate is, would you advise the firm to choose the forward contract or the put option? Explain briefly.
Question 2. The Campbell Soup Company has just agreed to purchase £5 million worth of potatoes from its supplier in northern England. Payment of the five million pounds was to be made in 245 days' time. The dollar had recently plummeted against the British pound and the CFO of Campbell, Steve Parker, wanted to avoid any further rise in the cost of imports. He viewed the dollar as being extremely unstable in the current environment of economic tensions. Having decided to hedge the payment, he obtained $/£ quotes of $2.25 spot and $2.19 for 245 days forward delivery. Parker's view, however, was that the dollar was bound to rise in the next few months, so he considered purchasing a call option. At a strike price of $2.21, the best quote he got was from Yorkshire Bank, which would charge a price of 0.85 percent of the principal. (Assume this is 0.85% of the dollar value of the pound purchased, based on the strike price.)
Parker decided to buy the call option, saying "In a highly volatile market where crazy currency values can be reached, options make more sense than taking your chances in the market, and you're not locked into a rock-bottom forward rate."
A) What will Campbell Soup Company do and how much will the potatoes cost if the pound rises to $2.31 245 days from now?
B) What will Campbell Soup Company do and how much will the potatoes cost if the pound falls to $2.10 245 days from now?
C) Given these two scenarios, do you think the call option was better than a forward contract? Why or why not?
Question 3. In "Why derivatives don't reduce FX risk," The McKinsey Quarterly, 1996 Number 1, Thomas E. Copeland and Yash Joshi describe the following case:
In the mid-1980s, a European airline contracted for several billion dollars' worth of Boeing 747s and 767s. The US dollar was strong at that time, and consensus was that it could go higher. Being short the dollar on its Boeing transaction, the airline bought roughly the same amount of dollars using forward contracts. If the dollar strengthened, the airline would lose on its Boeing contracts but win on its forward position. Therefore the airline had created a transaction hedge.
Unfortunately, even though the airline is European, its cash flows are positively correlated with the dollar, especially on transoceanic routes. If the dollar weakens, ticket prices in the home currency need to fall in order to keep the quantity sold relatively constant; therefore sales revenues decline. Furthermore, equipment and fuel costs fall in the local currency, while personnel, overhead, and other costs remain constant. In sum, the company takes in less cash if the dollar weakens, and more cash if the dollar strengthens.
A) Sketch the exposure lines for (1) the airplane purchase, (2) the forward contract, and (3) the airline's operating cash flows. Be sure to label your graphs clearly.
B) The dollar fell about 40% from February to December 1985. How was the airline affected (assuming the situation as described above)?
C) Based on your answers in (A) and (B), were the forward contracts a good idea? Explain why or why not.
Question 4. A U.S. electronics firm has been invited to bid on a contract to supply the Swiss power authority with switching systems. Bids must be made in Swiss francs. Bids are also to be submitted by French and Japanese firms, both of whose governments are keen on winning the contract. The result of the tender will be known some time during the following two months. If its bid is accepted, the American firm will receive an initial payment of two million Swiss francs, with the remainder of the payments made inSwiss francs at fixed dates thereafter. The firm must decide whether/how to hedge the possible Swiss franc receipts.
A) Compare the advantages and disadvantages of the following three strategies:
1) No hedging
2) Sell the anticipated Swiss franc receipts in the forward market at the currently quoted exchange rates for two months forward and the other future payment dates.
3) Purchase options to sell Swiss francs on the payment dates (put options).
B) What additional information do you need to decide among these strategies?
Question 5. Consider the Albion computers case in Chapter 9. Describe two operational hedging strategies that Albion could use to mitigate the projected operating losses due to the pound depreciation. Briefly compare the advantages and disadvantages of your proposed strategies. [Note: Do not include financial hedging strategies (derivatives); I am only interested in operational ones.]