Question

Payless Shoes has a shoe contract with a Hong Kong customer. Payless Shoes will pay 30 million Hong Kong dollars (HK$) and is due in three months. The current spot and 3-month forward exchange rates are $0.13/HK$.

a.    Form a forward market hedge.

b.  Indicate how the hedge eliminates foreign exchange exposure by identifying the forward contract’s cash inflows and outflows on a timeline. Draw Payless’ expected future cash flow in Hong Kong dollars on a timeline.

c.  Indicate how the hedge eliminates foreign exchange exposure using the payoff profile graph.

Answer 1

Payless Shoes have to pay 30million HK$ (Hong kong dollars) in three months time.

Spot and forward exchange rates are same i.e $0.13/HK$  

As company going to pay in three months hence current spot rate need not to consider.

Payless company US Based company as $ is the home currency

As payless company belongs to US hence it is in direct Quote it means $0.13 per HK $

a) Form a forward market hedge.

If the company takes forward market hedge then total payable amount after three months will be

1HK $ $0.13

30million HK$ ?

Hence total cost to Payless shoes after three months will be $3.9million

b.  Indicate how the hedge eliminates foreign exchange exposure by identifying the forward contract’s cash inflows and outflows on a timeline. Draw Payless’ expected future cash flow in Hong Kong dollars on a timeline.

Ans: If the $ appreciates against HK$ after three months

Example: $0.13/HK$ to $0.12/HK$

The payable amount will be reduced to $3.6million

If the $ Depreciates against HK$ after three months

Example: $0.13/HK$ to $0.14/HK$

the payable amount will be increased  to $4.2million

Forward exchange contract will be beneficial if $ Depreciates against HK$

If $ Depreciates $0.14 total benefit to payless $0.3million ($4.2 million - $ 3.9 million)

c.  Indicate how the hedge eliminates foreign exchange exposure using the payoff profile graph.

Ans:

with first diagram we can see the positive pay off when $ appreciates aganist HK$

With Second diagram we can see the negative pay off when $ Depreciates aganist HK$