Question

WaFlo Co is a JAMES-based company which has the following expected transactions..

One month: Expected receipt of                         $240,000

One month: Expected payment of          $140,000

Three months: Expected receipts of      $300,000

As the Corporate Finance Manager for WaFlo CO. you collect the following information:

Spot rate ($ per $):                                1.7820 ± 0.0002

One month forward rate (($ per $):         1.7829 ± 0.0003

Three months forward rate (($ per $):    1.7846 ± 0.0004

Money market rates for WaFlo Co:

                                                                        Borrowing                     Deposit

One year dollar interest rate:                             4.9%                            4.6

One year kwacha interest rate:                          5.4%                            5.1

Assume that it is now 1 April.

Required:

(a) Discuss the differences between transaction risk, translation risk and economic risk.

(b) Explain how inflation rates can be used to forecast exchange rates.

(c) Calculate the expected dollar receipts in one month and in three months using the forward market.

(d) Calculate the expected dollar receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used.

(e) Discuss how Kwacha currency futures contracts could be used to hedge the three-month dollar receipt.

Answer 1

a) Transaction Risk - The risk that results from actual foreign currency transactions i.e the risk that the foreign currency will move adversely leading in a loss from the transaction.

Translation Risk - The risk that the balance sheet items of the company denominated in foreign currency will change due to translation on the reporting date to domestic currency for reporting purposes. It results in unrealized gain/loss.

Economic Risk - The risk related to uncertainty of the future cash flows that will be realized from a transaction.

b) The country with higher inflation will see its currency depreciate as people will prefer to buy from the country with lower inflation and thus the demand for the higher inflation country will go down leading to currency depreciation.

It must be noted however that inflation is just one of the several factors affecting exchange rate.

c) In one month, the net receipt is Kwacha 100000 ( 240000 - 140000).

This will be converted at forward rate of (1.7829+0.0003) = 1.7832

Thus, $ receipt = 100000/1.7832 = $56,079

After 3 months, the expected receipt is Kwacha 300000.

Forward rate = 1.7846+0.0004 = 1.7850

Thus, $ receipt = 300000/1.7850 = $168,067

d) Money market hedge :

Borrow in Kwacha for 3 months at 5.4% such that total payable after 3 months is Kwacha 300000.

The amount borrowed = 300000 / (1+0.054/4) = Kwacha 296004

Convert Kwacha 296004 at spot rate to $ and invest in $ for 3 months @ 4.6%

296004/(1.7820+0.0002) = $166089 - Kwacha converted at spot to $

This amount earns interest on $ deposit.

Thus, total dollar amount with us at end of 3 months = 166089 * (1+0.046 / 4 )= $167999

The forward hedge is better as it results in higher dollar amount at the end of 3 months compared with money market hedge.