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17.3: Assignment- Exchange Rates and International Finance

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• Page ID 48544

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Microeconomic Question:

When a U.S. domestic producer begins selling exports, they typically need to worry about the foreign exchange market, since often the revenues an exporter earns are foreign currencies that then need to be traded into dollars. Because the foreign exchange value of the dollar tends to fluctuate, this adds an additional level of risk to the exporter’s business. What are some factors that would make a domestic producer willing to take on this extra and new type of risk?

Macroeconomic Question:

Changes in the value of a nation’s currency affect the nation’s net exports, and thus GDP. How might this make a large country, like the U.S., more willing to adopt a flexible exchange rate regime than a small country, like Belgium.

Contributors and Attributions

• Assignment: Exchange Rates and International Finance. Authored by : Steven Greenlaw and Lumen Learning. Provided by : Lumen Learning. License : CC BY: Attribution

Chapter 7 Foreign Exchange and the Global Capital Markets

End-of-chapter questions and exercises, experiential exercises [2].

• You work for a global auto-parts company. Describe how you would use the spot and forward markets to manage the potential exchange rate risk between the countries from which you import (buy) components and the countries in which you sell auto parts. Select any three currencies to use in your discussion.Access the following URL from fxstreet.com: http://www.fxstreet.com/rates-charts/forward-rates . Use it to determine if forward or futures contracts are available in all the currencies you selected.
• You are working for the CFO of a global food-products company with extensive operations in North America, South America, Europe, Africa, and Asia. The firm is creating a new finance subsidiary to manage a number of financial transactions, including its foreign exchange, financing, and hedging transactions. Your CFO has asked you to prepare an analysis of two offshore financial centers—Bermuda and Luxembourg. Research the pros and cons of each center and make a recommendation to your CFO.

Ethical Dilemmas [3]

• Imagine that you are the finance manager in control of purchasing for a small manufacturing company. Your supplier in Russia tells you that there are two quotes, one for payments in US dollars by wire transfer or check and one for a US dollar cash-like transaction. The cash transaction is almost 10 percent cheaper, which could earn your firm a nice profit and a potential year-end bonus for you. How do you handle the phone call and the decision? Discuss the ethical and business issues involved. If you decide against the cash-like transaction, do you tell your senior management? What do you recommend to your management about future dealings with this supplier? Russia is one of the most corrupt countries for businesses. What options does your firm have if it needs to source from Russia? Use fxstreet.com ( http://www.fxstreet.com/rates-charts/ ) to research and discuss more.
• Global companies transact business in multiple countries and currencies. Using information you learned in this chapter, discuss whether companies should set up offshore companies to manage their currency and financial transactions. More specifically, if you worked for Walmart, would you recommend that the firm set up an offshore company? Why or why not?
• Association to Advance Collegiate Schools of Business website, accessed January 26, 2010, http://www.aacsb.edu . ↵
• (AACSB: Communication, Use of Information Technology, Analytical Skills) ↵
• (AACSB: Ethical Reasoning, Multiculturalism, Reflective Thinking, Analytical Skills) ↵
• Challenges and Opportunities in International Business. Authored by : Anonymous. Provided by : Anonymous. License : CC BY-NC-SA: Attribution-NonCommercial-ShareAlike . License Terms : The publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URL to be removed.

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• How to answer a foreign exchange risk management question
• Study resources
• Advanced Financial Management (AFM)
• Technical articles and topic explainers
• Back to Advanced Financial Management (AFM)
• How to approach Advanced Financial Management

The Advanced Financial Management syllabus states that there will be at least one question with a focus on syllabus section E, Treasury and advanced risk management techniques. Within Section E, foreign exchange risk management is frequently examined. This article will explain the significance of the information you’ll be given in foreign exchange risk management questions and show you what you’ll be asked to do.

The scenario is adapted from Nutourne Co, Question 2 in the December 2018 exam, which ACCA published. Some of the numbers have been changed. In this question, the closing futures price and spot rate are not given and so the predicted futures rate has to be calculated. (See the article ' Exchange traded foreign exchange derivatives ' for an example of when the spot rate and futures price on the day of settlement are given). There is also a spreadsheet provided showing how the calculations could be set out in the spreadsheet tool in the exam.     

Nutourne Co is a company based in the USA , supplying medical equipment to the USA and Europe. Nutourne Co’s treasury department hedges foreign exchange risk on transactions using forward contracts, the money market, traded futures or traded options.

It is currently 30 November 20X8.

Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed , where the customer will pay for the equipment on 31 May 20X9.

Annual interest rates available to Nutourne Co

Currency futures (contract size CHF125,000, futures price quoted as US$ per $1)

Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1)

If futures or options are chosen, any amount not hedged by a futures or options contract will be hedged on the forward market.

Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. 

Required: Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt, assuming the options are exercised.

Approaching the question

Read the requirements carefully You must read the requirements before reading the scenario in detail. Knowing what you have to do will help you analyse the scenario and ensure that you answer the question fully.

Breaking down the requirements for Nutourne Co:

Identify the important data in the scenario

• Hedging methods to be used
• Transaction to be hedged
• Time period
• Spot and 6 month forward rates

Hedging methods to be used The scenario states that the following methods should be considered:  

• Forward contracts
• The money market
• Traded futures
• Traded options

Transaction to be hedged Nutourne Co is a company based in the USA … currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed.

Nutourne Co needs to hedge against the USD strengthening (the CHF weakening).

Implications for hedging methods

Time period It is currently 30 November 20X8… the customer will pay for the equipment on 31 May 20X9.

Two things to note:

• The length of time between today’s date (30 November 20X8) and the date of settlement (31 May 20X9) – 6 months
• The date of settlement – 31 May

1.0292 – 1.0309 (quoted as US$/CHF 1)

Remember that the bank ‘always wins’ – so if there is a choice of two exchange rates, choose the one that gives the lowest receipt.

6 month forward rate

1.0356 – 1.0378 (quoted as US$/CHF 1)

6 month rate is used, as it is 6 months between today‘s date (30 November) and date of settlement (31 May).   

Remember again that the bank ‘always wins’.

ANSWER Let’s now review the answer:

Forward contract Receipt = CHF12,300,000 × 1.0356 = $12,737,880

Money market hedging

Amount borrowed = CHF12,300,000 /(1 + [0.044/ 2 ]) = CHF12,035,225

• Convert into US$ at spot rate

Receipt = CHF12,035,225 × 1.0292 = US$12,386,654

• Invest in US$

Receipt = US$12,386,654 × (1 + [0.046/ 2 ])  = CHF12,671,547

• Sell CHF futures
• Use June CHF futures contracts
• Number of contracts

Number of contracts = CHF12,300,000 /125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000

• Remainder to be hedged on forward market  

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = $51,780

• Futures price and expected receipt

Estimate from March and June futures rates

Predicted futures rate at the end of May = 1.0336 + ([1.0369 – 1.0336] × 2/3 ) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550

Estimate from spot rate and June futures rate

Predicted futures rate at the end of May = 1.0292 + ([1.0369 – 1.0292] × 6/7 ) = 1.0358

• Buy CHF put options
• Buy June options
• Number of contracts and receipt

Number of contracts = CHF12,300,000 /125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000 (as for futures)

Receipt = CHF125,000 × 98 × 1.0375 = $12,709,375

Receipt = CHF50,000 × 1.0356 = $51,780 (as for futures)

1.0375 options = 98 × 125,000 × 0.0086 = $105,350

If the options are exercised, the futures would give the higher receipt. The options give a lower receipt because of the premium that Nutourne Co has to pay. The futures will be subject to the risk that basis (the difference between the futures price and the spot price) may not decrease linearly as the futures approach maturity, as assumed in the above calculations. This will mean that the hedge of the CHF12,250,000 is imperfect, and the receipt may be unpredictable despite a futures hedge being taken out.    

This question has demonstrated how to use the data given in the question in foreign exchange hedging calculations. Hopefully, it will help you tackle this type of question systematically.     

View an example of how the question could be attempted in the exam software

Written by a member of the AFM examining team

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