Question

(a)Determine the present value of the expected future cash flowassuming:

            (1) There is no hedge.

            1815 Gallons * BRL 90.15 = 163,622

            Exchange Rate = 0.4234

            Covert to USD = $69,277.55

            Interest Rate of USD = 0.0215

            Present Value In USD =. $67,819.44

            

            (2) The company hedges using a forward contract

1815 Gallons * BRL 90.15 = 163,622

Exchange Rate = 0.4227

Convert to USD = $69,163.02

Interest Rate of USD = 0.0215

Present Value in USD = $67,707.31

            (3) The company using the money market.

1815 Gallons * BRL 90.15 = 163,622

Interest Rate of BRL = 0.065

BRL to borrow = 153,635.68

Exchange Rate = 0.4368

Covert to USD = $67,108.07

Present Value in USD = $67,108.07

            

                        (4)Bedsides the forward and money market, long option on $ is another way to hedgethe currency risk. Assume the option strike price is $0.4010/Real and 1% fee paid up front. If thespot exchange rate in 3 months is $0.4234/Real, what is the present option value of the sale?

             Cash flow after 3 months = Spot exchange rate * Receivables

             Cash flow after 3 months = 0.4234 * 163622

             Cash flow after 3 months = $69277.55

             Present value = Cash Flow * 1 / (1 + 3-month interest) - Premium paid

             Present value = 69277.55 * 1 / (1 + 0.0215) - 163622 * 0.4010*1%

             Present value = 67819.44 - 656.12

             Present value of = $67,163.32

Finding a present value is necessary for the following reason: With no hedge or a with a forward- contract hedge, the cash flow will occur at the time of payment by Novo. With the money-market hedge, Baker receives a cash flow immediately. To compare the cash flow outcome of all hedge strategies, we must compare the present value of them.

(b) Which way is preferred?

Answer 1

Whole answer is given assuming entity X's view point. Entity X has BRL 163622 receivable in future after one year due to some to export orders, so it is considering strategies to minimise foreign currency exposure - whether to hedge or not?

Strategy which gives highest $ inflow at end of highest PV of $ today will be best strategy.

a) Present value is necessary for assessing the usefulness of different hedge strategies because cash flows occur at diffrent points of time in every case.

For instance, if exposure of BRL is left unhedged then $ inflow will be at the time of payment by other party which is one year in our example and would entail inflow of $69277 and if we enter into forward contract then inflow will be $67707.

However in money market transaction, we need to borrow so much of BRL which would give us required BRL what ch is 163622 after one year. So we need to borrow only 153635 BRL today which will grow @6.5% would become 163622 after one year. So when we receive BRL in future as export payments we can use to repay our BRL loan. Now we will sell the borrowed 153635 BRL at market price and convert into USD getting $67108.

Now we can see $67108 lies at today while in alternative 1 & 2, inflow stand after one year, so in order to have the comparison, we need to either compare the PV or FV.

b) Alternative 1 gives the highest $ inflow in PV terms so it must be preferred. However this will be true only if exchange rate behave as predicted by us.

Note - If we are talking from payer's view point then strategy having lowest outflow is preferred which is alternative 3.