Question

Managing transaction risk

Assume the following:

The current exchange rate for the Chinese yuan is 6.3159.

The 120-day US interest rate is 2.125%.

The 120-day Chinese interest rate is 4.35%.

The 120-day forward rate for Chinese yuan is 6.3464.

A US firm is required to make a payment of ¥1,000,000 to a supplier in 120 days.

1. If the value of the Chinese yuan does not change, what will the dollar cost of the payment be?

2a. Describe how the firm can hedge the transaction risk associated with the payment using a money market hedge.   

b. What will the dollar cost of the payment be if the firm hedges the transaction risk with a money market hedge and the spot exchange rate for Chinese yuan in 120 days turns out to be 6.3900?

3a. Describe how the firm can hedge the transaction risk associated with the payment using a forward market hedge.

b. Explain what will happen using this forward market hedge if the spot exchange rate in 120 days is 6.8900.

4. Describe how the firm can hedge the transaction risk associated with the payment using a currency option.

5. How could the firm hedge the transaction risk associated with this payment by exposure netting or funds adjustment?

6. How can the firm use leading or lagging to its advantage in connection with this payment?

7. How would the answers to the previous questions change in the firm expected to receive a payment of ¥1,000,000 in 120 days rather than making a payment?

Answer 1

1. If the value of the Chinese yuan does not change, what will the dollar cost of the payment be?

If the value of the Chinese yuan doesnt change, the dollar cost of the payment will be calculated by dividing the total value of payment with the current exchange rate of $6.3159

Dollar cost of the payment = = $158,331

2a. And 2b.

Describe how the firm can hedge the transaction risk associated with the payment using a money market hedge.

Currency risk exposure could be hedged with money market instruments, there are multiple options available by taking opposite position in money market instruments so that it can neutralise the currency fluctuation risk associated with the exposure.

One of the methods hedging currency exposure is adjusting the interest rate differentials between the spot rate and forward exchange rate. 'Covered interest rate parity' holds that the in due course of time the forward exchange rates should incorporate the interest rates differenctiails between the underlying countries of the currency pair.

b. What will the dollar cost of the payment be if the firm hedges the transaction risk with a money market hedge and the spot exchange rate for Chinese yuan in 120 days turns out to be 6.3900?

Expected forward rate = Yuan * (1+interest rate in China)/(1+interest rate in US) = 6.3159 * = 6.4535

USD cost at forward rate = 1,000,000/6.4535 = 154,955

120 day forward exchange rate for Chinese Yuan = 6.3434

Cost in USD at forward rate = 1,000,000/6.3434 = 157,570

It is evident that the cost of 157,570 could be settled at 154,955 using money market hedge.

Given in the question: Spot exchange rate in 120 days = 6.39

Payment = 1000,000/6.39 = 156,495

Cost in Money market hedge = (154,955)

Gain in money market hedge = 156,495 - 154,955 = 1540

3a & 3b.

Describe how the firm can hedge the transaction risk associated with the payment using a forward market hedge.

Expected forward rate = Yuan * (1+interest rate in China)/(1+interest rate in US) = 6.3159 * = 6.4535

USD cost at forward rate = 1,000,000/6.4535 = 154,955

120 day forward exchange rate for Chinese Yuan = 6.3434

Cost in USD at forward rate = 1,000,000/6.3434 = 157,570

It is evident that the cost of 157,570 could be settled at 154,955 using money market hedge.

Given in the question: Spot exchange rate in 120 days = 6.89

Payment = 1000,000/6.89 = 145,138

Cost in Money market hedge = (154,955)

Loss in money market hedge = 145,138 - 154,955 = (-9817)

Hence the gain will be converted into loss

b. Explain what will happen using this forward market hedge if the spot exchange rate in 120 days is 6.8900.

Expected forward rate = Yuan * (1+interest rate in China)/(1+interest rate in US) = 6.3159 * = 6.4535

USD cost at forward rate = 1,000,000/6.4535 = 154,955

120 day forward exchange rate for Chinese Yuan = 6.3434

Cost in USD at forward rate = 1,000,000/6.3434 = 157,570

It is evident that the cost of 157,570 could be settled at 154,955 using money market hedge.

Given in the question: Spot exchange rate in 120 days = 6.89

Payment = 1000,000/6.89 = 145,138

Cost in Money market hedge = (154,955)

Loss in money market hedge = 145,138 - 154,955 = (-9817)

Hence the gain will be converted into loss

4. Describe how the firm can hedge the transaction risk associated with the payment using a currency option.

Using currency options. The firm can buy either buy call or put options to hedge the exchange risk exposure.

In this case the US firm is expected to buy Chinese Yuan in order to pay to the supplier in 120 days.

Option 1. The Firm can buy currency call option to buy Yuan against USD. The call option gives the right to buy the currency at the predetermined price of 6.3159 after 120 days. Please note that there is no obligation to perform the contract at expiry. If the exchange rate is lower than the 6.3159, the US firm will get more of chinese Yuan at lesser Dollar cost, hence will not exercise the option.

Option 2. If the Currency exchange rate is more than the current exchange of 6.3159, the dollar cost will increase, hence the firm can exercise the call option and buy the currency at 6.3159 to avoid currency fluctuation problem.