Question

Lets say you are a foreign student studying in US and you have to pay $15000 tuition next August. You are worried that your home currency may depreciate compare to dollar. What can you do to avoid that risk?

PROFESSOR'S GUIDANCE THIS WEEK'S LE:

This is an example of an exposure to a foreign currency and ways one can eliminated the risk of that exposure in advance. Remember risk in finance in the uncertainty with respect to the outcome. In this case you don't know what the exchange rate is going to be next august.

Answer 1

Unforeseen fluctuations in the foriegn currecy exchange rate may lead to favourable or unfavourable impact on the cashflow and that's known as Transaction Exposure.

Student mentioned in the question is exposed to Transaction risk.We can avoid the risk way in advance by following any of the alternatives mentioned below;

1. Hedging in forward Contract:- Student can enter into forward contract with a bank to buy the $15,000 in the future at the rate fixed today. Here, the liability is fixed even though exchange rate may fluctuate.

2. Foriegn Currency Option:- It's the right to buy or sell the currency at future date at pre-determined excercise rate. Student shall enter into buying a call option which gives right to buy $15,000 in future at rate fixed today. If the price goes below the pre-determined price, student will have the right to reject the contract and buy the $ in market.

3. Money Market Hedge:- It's a simultaneous borrowing and lending activity in different currencies that are exposed to. Student can invest present value of $ now by borrowing his home currency. At the payment date, Invest will mature and give $15,000 which can be paid as fee. The borrowed amount with interest will be his cost irrespective of changes in exchange rate.