Question

ABC is a United States company that has a manufacturing subsidiary in Brazil. There have been large changes in the USD/BRL exchange rate over the last 5 years and the company has forecasted the following possible exchange rates and subsidiary values over the next year:

	Probability	USD/BRL	Value (BRL)	Value ($)
State 1	.2	$1 = 2.93 BRL	60,000,000	20,477,816
State 2	.2	$1 = 3.24 BRL	55,000,000	16,975,309
State 3	.2	$1 = 3.35 BRL	52,000,000	15,522,388
State 4	.2	$1 = 3.46 BRL	49,000,000	14,161,849
State 5	.2	$1 = 3.76 BRL	44,000,000	11,702,128

(a) Find the exchange exposure coefficient faced by ABC for its Brazilian subsidiary (i.e. find the b estimate from a regression)

(b) Describe in detail a hedge you could put in place to reduce this exchange exposure over the next 12 months using forward contracts.

(c) Show the effect of the hedge on the value of the subsidiary in $ if each state of the world occurs.

Answer 1

Exchange exposure coefficient = Cov(Exchange Rate,Dollar value of Asset)/ Variance of Exchange Rate

(b) As a USA company would tend to gain if BRL appreciates, so to hedge company should short forward contracts on BRL. Assuming current exchange rate is $1= BRL 3.35. The company should forward contracts at current price.

(c) If the value of currency gets to state 1 or 2, company's losses would be compensated from the forward contract and would not be affected.

In case of state 3, company would losse only the premium paid to enter the contract. In case of State 4 and 5 company would be benefited from increase in value and would have to just pay premium on the contract entered.