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Three month forward rate

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Hello!

Would someone please provide me with a step by step solution for the following problem?

A U.S. corporation, Forever Young, Inc., intends to import \$1,000,000 worth of cosmetics from Switzerland and will make payment in SF three months from now.The foreign exchange spot rate of Swiss franc to the U.S. dollar is SF6/\$. Annual interest rates for U.S. dollar and Swiss franc are 5 percent and 8 percent, respectively.

a. What is the three-month forward rate for French franc if interest-rate parity holds?
b. How can Forever Young, Inc., use currency trading to hedge against the foreign exchange risk associated with the purchase?

Solution Preview

Three month forward rate=
f 3month = (1+rsf/1+ru)*e
rsf= rate of interest of sf
rusa= rate of interest of usa
e = Exchange rate
This rate will be divided by 4 to get three monthly returns :
(1+.08/4)/(1+.05/4)*6
=(1.02/1.0125)*6
=\$6.044
b. How can Forever Young, Inc., use currency trading to hedge against the foreign exchange risk associated with the purchase?

Forever faces the currency risk. It should manage the risk in following manner:

Translation exposure
is simply the difference between exposed assets and exposed liabilities. The controversies among accountants' center on which assets and liabilities are exposed and on when accounting-derived foreign exchange gains and losses should be recognized (reported on the income statement). A crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature-that is, no cash flows are necessarily involved.
Firms have three available methods for managing their translation exposure: (1) adjusting fund flows, (2) entering into forward contracts, and (3) exposure netting.

Essentially, the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets, while simultaneously decreasing hard currency liabilities ...

Solution Summary

This provide the steps to compute the three month forward rate

\$2.19
Similar Posting

Hedging and International currency issues

By David k. Eiteman

Chapter 8 and 9 problems

TA please note Some example problems are available at www.aw.com/eiteman
By chapter

Page 221

5. Tek Italian accounts receivables. Tek wishes to hedge a &#1028;4,000,000 account receivable arising from a sale to Olivertti (Italy). Payment is due in three months. Tek's Italian unit does not have ready access to local currency borrowing, eliminated the money market hedge alternative. Citibank has offered tek the following quotes:

spot rate \$.9800/&#1028;
3-month forward rate \$.9850/&#1028;
3-month euro interest rate 6.000% per year
3-month put option on euros
at strike price of \$0.9800/&#1028; 3%
Tek's weighted average cost of capital 12%

a. what are the cost of each alternative?
b. What are the risks of each alternative?
c. What alternative should Tek choose if it prefers to play it safe?
d. Which alternative should tek choose if it is willing to take a reasonable risk and has a directional view that the euro may be appreciating versus the dollar during the next three months?

6. Tek-Japanese account payable. Tek has imported components from its joint venture in Japan, Sony, tek with payment of ¥8,000,000 due in 6 months. Citibank has offered Tek the following quotes.

Spot rate ¥125/\$
6-month forward rate ¥122/\$
6-month yen deposit rate 1.5000% per year
6-month dollar interest rate 4.000%
6-month call option on yen
at a strike price ¥125/\$ 4%
Tek weighted average cost of capital 12%

a. what are the cost of each alternative?
b. What are the risks of each alternative?
c. Which alternative should tek choose if it is willing to take a reasonable risk and has a directional view that the yen may be depreciating versus the dollar during the next 6 months?

7.Tek british telecom bidding. Tek has made a £1,000,000 bid to supply and install a networking monitoring system for British telcom in Manchester UK. The bid is good for 30 days at which time the winner of the bidding process will be announced. Other bidders are expected to be Agilent, Siems and at least two British frims. If tek wins the bid it will have 60 days to build and install the system. During this 90 day period the £1,000,000 will be accounted for as a backlog upon delivery and testing of the system British telecom will make full payment 30 days later. During the month Tek will account for the £1,000,000 as an account receivable. Barclay's bank (UK) has offered teck the following quotes:

spot rate \$1.5700/£
4-month forward rate 1.5720/£
1 month £ investment rate 4% per year
1 month £ borrowing rate 9% per year
4 month £ investment rate 4.250% per year
4 month £ borrowing rate 9.200% per year
1 month put option on pound
4 month put option on pound

Teks weighted average cost of capital 12%

What should tek do to hedge this bid?

8. Tek swedish price list- Tek offers oscilloscopes and other off the self products through foreign currency denominated price lists. The prices are valid for three months only. One example is a swedish price list expressed in swedish Kronor. In effect customers are given a cost free call option on products with a fixed dollar/krona exchange rate. During a typical three month period Tek could expect to sell SKr5,000,000-Skr 10,000,000 worth of products basee on the price list. Since the SKr/\$ exchange rate is likely to change during any three month period. Tek would like to hedge this transaction exposure (although Tek' swedish business unit does not believe the Krona will be wreaking versus the dollar in the coming months. Nordea Bank Sweden has offered Tek the following quotes:

spot rate SKr9.20/\$
3 month forward rate SKr9.25/\$
3 month korma interest rate 6.15%/ year
3 month korma borrowing rate 12.50%/year
3 month dollar interest rate 4.00%/year
3-month put option on Korma
at strike price of Skr9.20/\$ 3.5%

Teks weighted average cost of capital 12%

a. Whar are the cost of each alternative for hedging Skr5,000,000?
b. What are the risks of each alternative? How much Kronor should tek hedge if it wants to play it safe?
c. What alternatives should tek choose if it is willing to take a reasonable risk and has directional view that the Swedish Korma will appreciate versus the US dollar in the next three months?

16. Aqua pure- Aqua pure is a us based company that manufactures and sells and install water purification equipment. On April 20, the company sold a system to the city of Nagasaki Japan, for installation in Nagasaki's famous Glover Gardens (where Puccini's Madame butterfly waited for the return of Lt pinkerton). The sale was priced in yen at ¥20,000,000 with payment due in three months. On the day of the sale the Financial times published the following mid-rates for the yen:

Spot exchange rate ¥118.255/\$
(closing mid rate)
1 month forward rate ¥117.760/\$
3 month forward rate ¥116.830/\$ a
1 year forward ¥ 112.450/\$ a
Money rates
(% pa) US Japan Differenetial

1 month
4.8750%
0.09375%

4.78125%

3 month 4.9375%
0.09375%

4.84375%

12 month
5.1875%
0.31250%
4.87500%

NOTE; the interest rate differential vay slightly form the forward discounts on the yen because of the time differences for the quotes. The spot ¥118.255/\$ for example is a mid point range. On april 20 the spot yen traded in London from ¥118.20/\$ to ¥117.50/\$

Additional information aqua pure's Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese money rate. Aqua pure's weighted average cost of capital is 16% and the company wishes to protect the dollar value of this receivable.

Call option on ¥20,000,000 at exercise price of ¥118.00/\$ 1% Premium

Put option on ¥20,000,000 at exercise price of ¥188.00/\$ 3% premium

a. What are the costs and benefits of alternative hedges? Which would you recommend why?
b. What is the break-even reinvestment rate when comparing forward and money market alternatives?

18. Redwalll pump company- on march 1 redwall pump company sold a shipment of pumps to Vollendam dike company of the Netherlands for â?¬4,000,000 payable â?¬2,000,000 on June 1 and â?¬2,000,000 on September 1. Redwall derived its price quote of â?¬4,000,000 on February 1 by dividing its normal US dollar sales price of \$4,320,000 by the then current spot rate of \$1.0800/â?¬. By the time the order was received and booked on march 1, the euro had strengthened to 1.1000/â?¬ so the sale was in fact worth â?¬4,000,000 x\$1.1000/â?¬=\$4,400,000 redwall had already gained an extra \$80,000 from favorable exchange rate movements. Nevertheless redwall's director of finance wondered if the firm should hedge against a reveal of the recent trend of the euro. Four approaches are possible here:

a. Hedge in the forward market. The 3 month forward exchange rate quote was \$1.1060/â?¬ and the 6 month forward quite was \$1.1130/â?¬
b. Hedge in the money market Redwall could borrow euros from the Frankfurt branch of its US bank at 8.00% per annum.
c. Hedge with foreign currency options June put options were available at strike price of \$1.1000/â?¬ for a premium of 2.0% per contract and September put options were available at \$1.1000/â?¬ for a premium of 1.2%. June call options at \$1.1000/â?¬ could be purchased for a premium of 3.0% and septemeber call options at \$1.1000/â?¬ were available at a 2.6% premium.
d. Do nothing Redwall could wait until the sales proceeds were received in June and September hope the recent strengthening of the euro would continue and sell the euros received for dollars on the spot market.

Redwall estimates its cost of equity capital to be 12% per annum a small firm redwall is unable to raise funds with long term debt. US T bills yielded 3.6% per annum. What should redwall do?

Chapter 9 problems page 262

5. Hawaiian Macadamia nuts Hawaiian macadamia nuts based in Hilo Hawaii exports macadamia nuts worldwide. The Japanese market is its biggest export market with average sales invoiced in to the japanse customer of ¥1,200,000,000. At the exchange rate of ¥125/\$ this is equal to \$9,600,000. sales are relatively equally distributed during the year. They show up as a ¥250,000,000 account receivable on Hawaiian Macadamia nuts balance sheet, Credit terms to wach customer allow for 60 days before payment is due. Month cash collections are typically ¥100,000,000.
Hawaiian Macadamia nuts would like to hedge its receipts, but it has to many customer transactions to make it practical to sell each receivable forward. It does not wan to use options because they are considered to be too expensive for this particular purpose. There fore it shad decided to use a "matching hedge" by borrowing yes at 4% per annum.

a. How much should Hawaiian Macadamia nuts borrow in Yen?
b. What should be the terms of payment on the yen loan?

6. Cellini fashion wear based in NYC imports leather coasts from boselli leather goods a reliable and long time supplier bases in Buenos Aries, Argentina payment is in Argentine pesos. When the peso lost its parity with the us dollar in January 2002 it collapsed in value to Ps4.0/\$ by October 2002 The out was for a further decline in the peso's value. Since both Cellini fashion and beselli leather goods wanted to continue their longtime relationship they agreed on a risk sharing arrangement. A long as the spot rate on the date of an invoice is between Ps3.5/\$ and Ps4.5/\$ Cellini will pay based on the spot rate. If exchange rate falls outside this range it will share the difference equally with boselli. The risk sharing agreement will last for six months at which time the exchange rate limits will be reevaluated. Celeinii contracts to import leather coats from Boselli for Ps8,000,000 or \$2,000,000 at the current spot rate of Ps4.0/\$ during the next six months.

a. if the exchange rate changes immediately to Ps6.00/2 what will the dollar cost of six months of imports to Cellini fashion wear?
b. At Ps6.00/\$ what will be the peso export sales of Boselli leather goods to celini fashion wear?

10, Risk sharing at Harley Davidson Harley Davidson US reportedly uses risk sharing agreement with its own foreign subsidiaries and with independent foreign distributors Because these foreign units typically sell to their local markets and earn local currency, Harley would like to ease their individual currency exposure problems by allowing them to pay for merchandise from Harley US in their local functional currency. The spot rate between the us dollar and the Australia dollar on January 1 is A\$1.2823/\$ assume that Harley uses this rate as the basis for setting its central rate or base exchange rate for the year at A\$1.2800/\$. Harley agrees to price all contracts to Australian distributors at this exact exchange rate as long as the current spot rate on the order date is within +- 2.5% of this rate. If the spot rate falls outside this range, but still within +- 5% of the central rate, Harley will share equally the difference between the new spot rate and the neutral boundary with the distributor.

a. what are the specific exchange rates at the boundaries of the neutral and risk sharing zones?
b. If Harley US ships a motorcycle with an invoice of \$8500 to Australia and the exchange rate on the order date is A\$1.3442/\$,what is the price in Australian dollars?
c. If Harley US ships the same motorcycle to Australia and the exchange rate on the order days is A\$1.2442/\$, what is the price in Australian dollars to the foreign distributor.

Some example problems are available at www.aw.com/eiteman

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