Question

Suppose that Boeing (US company) sold airplane to Lufthansa (German company) on credit and invoiced €20 million payable in six months. Two companies agree to share the currency risks. In the Price Adjustment Clause, the neutral zone is $1.14/€ - $1.26/€, the base rate is $1.2/€; and both parties will share the currency risk beyond a neutral zone. How much each party have to pay/receive if:

How much each party have to pay/receive if the exchange rate is $1.32/€?

a. Boeing receives $24 million; Lufthansa pays €18.18 million.

b. Boeing receives $24.6 million; Lufthansa pays €18.64 million.

c. Boeing receives $26.4 million; Lufthansa pays €20 million.

d. Boeing receives $25.8 million; Lufthansa pays €19.55 million.

Answer 1

Interpretation of neutral zone- The base rate is $1.2/ €. The neutral zone is $1.14-1.26/ €. This implies that if the exchange rate at the time of payment (6 months later, when the amount is payable), is within this zone, the transaction will take place at the actual spot rate at the time and there will be no adjustment in the price. If however, the price is outside this zone, the price will be adjusted so that the net amount received by Boeing is as per the base rate of $1.2/ €. The net effect is that the company which has a favorable exchange rate will realize a lower price, as long as the other party receives the base exchange rate. In this case, since the exchange rate has increased in favor of Euro (Lufthansa), it will pay money as per the favorable exchange rate of $1.32/ €. Boeing on the other hand, will receive the selling price as per the base rate of $1.2/ €. Had the exchange rate been $1.14/ € or lower, Lufthansa would have paid the price at the base rate of $1.2/ € and Boeing would have received adjusted its selling price.

Transaction cost €	20,000,000
Actual Exchange rate	$1.32/ €
Actual Transaction cost $	26,400,000
Base rate Transaction cost $	24,000,000
Difference in transaction cost $	2,400,000

This cost is a reduction in price due to lower exchange rate. The difference in cost will be shared equally (50-50) by the 2 companies.

Share of Lufthansa in cost sharing $	2,400,000
Share of Lufthansa in cost sharing €	1,818,181.82
Effective purchase price for Lufthansa €	18,181,818.18
Effective selling price for Boeing $	24,000,000