Question

In: Finance

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable...

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in 1 year. Currently, the spot exchange rate is ¥105/$ and the 1 year forward rate is ¥100/$. The 1 year money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM are considering using a forward contract or a money market hedge to deal with this yen account payable.

a. What type of exposure does IBM face?

b. What should IBM use: a forward buy or sell, and of which currency? Why?

c. Briefly explain the process of a money market hedge and calculate the dollar cost of meeting the yen obligation at maturity via a money market hedge.

d. Which hedging alternative would you recommend? Why?

e. What type of foreign currency option could be used to hedge this exposure?

Expert Solution

a. IBM faces a transaction ( short-run) exposure.

b.IBM has Yen payable, hence IBM needs to buy Yen and sell dollar for settlement of its Yen obligation.Hence IBM should forward sell dollar or in other words forward buy Yen.

c.for entering money market hedge, IBM should invest in Yen the present value of Yen payable, and the investment should be made by selling dollar at todays spot rate, the amount of dollar required will be borrowed and repaid after 1 year.

amount payable = Yen 250 million in 1 year

Present value of payment = amount payable/(1+ yen interest rate) =250 million/(1+0.07) =250/1.07 million =Yen 233.64486 million

amount required in dollars to invest the above amount in Yen = amount of yen rerquired/ exchange rate = Yen 233.64486 million / 105 yen/ $ =$ 2.2251891 million

above amount will be borrowed in US for 1 year at 8% p.a.

amount payable after 1 year = loan* (1+ interest rate) = $ 2.2251891(1+0.08) million =$2.4032 million

d.Outflow via money market hedge =$ 2.4032 million (as in c).

Outflow via forward contract = Amount payable/ forward rate = Yen 250 million/ 100 Yen/$ = $2.5 million

Hence hedging should be done via money market hedge as outflow is lower.

e.To hedge the exposure, buy call option on Yen or buy Put option on dollar.

jeff jeffy answered 1 year ago

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