IF Solution to qn no.2a

(i)                   If Shoe Company were to hedge its foreign exchange risk, it would enter into forward contract of selling deutsche marks 90 days forward. It would sell 50,000 deutsche marks 90 days forward. Upon delivery of 50,000 DM 90 days hence, it would receive US $ 29,412 i.e. 50,000 DM/1.70. If it were to receive US $ payment today it would receive US $ 29,240 i.e. 50,000 DM/1.71. Hence, Shoe Company will be better off by $ 172 if it hedges its foreign exchange risk.

                 The deutsche mark is at a forward premium. This is because the 90 days forward rate of deutsche marks per dollar is less than the current spot rate of deutsche marks per dollar. This implies that deutsche mark is expected to be strengthen i.e. Fewer deutsche mark will be required to buy dollars.

(ii)                The interest rate parity assumption is that high interest rates on a currency is offset by forward discount and low interest rate on a currency is offset by forward premiums. Further, the spot and forward exchange rates moves in tandem, with the link between them based on interest differential. The movement between two currencies to take advantage of interest rates differential is a major determinant of the spread between forward and spot rates. The forward discount or premium is approximately equal to interest differential between the currencies i.e.  (F_(DM/US$) - S_(DM/US$) )/S_{(DM/US$) * 365/90} = r_Dm– r_us$;  (1.70-1.71)/1.71 * 365/90 = -0.0237 = r _Dm – r _us$ Therefore, the differential in interest rate is –2.37%, which means if interest rate parity holds, interest rate in the US should be 2.37% higher than in Germany.

(iii)                Foreign Exchange Rate Risk: This risk relates to the uncertainty attached to the  exchange rates between two currencies. For example, the amount borrowed in foreign currency is to be repaid in the same currency or in some other acceptable currency. Thus if the foreign currency becomes stronger than (say) Indian rupees, the Indian borrower has to repay the loan in terms of more rupees than the rupees he obtained by way of loan. The extra rupees he pays is not due to an increase in interest rate but because of unfavourable exchange rate. Conversely he will gain if the rupee is stronger. The fluctuation in the exchange rate causes uncertainty and this uncertainty gives rise to exchange rate risk.

(iv)                  The following tools are available to cover exchange rate risk: (a) Spot contracts. (b) Rupee forward contract. (c) Rupee roll over contract. (d) Cross-currency forward contract. (e) Cross currency roll over contract. (f) Cross currency options. (g) Currency futures. (h) Currency and interest rate swaps. (i) Arbitrage.

(v)   A firm dealing with foreign exchange may be exposed to foreign currency exposures. The exposure is the result of possession of assets and liabilities and transactions denominated in foreign currency. When exchange rate fluctuates, assets, liabilities, revenues, expenses that have been expressed in foreign currency will result in either foreign exchange gain or loss. A firm dealing with foreign exchange may be exposed to the following types of risks: (i) Transaction Exposure: A firm may have some contractually fixed payments and receipts in foreign currency, such as, import payables, export receivables, interest payable on foreign currency loans etc. All such items are to be settled in a foreign currency. Unexpected fluctuation in exchange rate will have favourable or adverse impact on its cash flows. Such exposures are termed as transactions exposures. (ii) Translation Exposure: The translation exposure is also called accounting exposure or balance sheet exposure. It is basically the exposure on the assets and liabilities shown in the balance sheet and which are not going to be liquidated in the near future. It refers to the probability of loss that the firm may have to face because of decrease in value of assets due to devaluation of a foreign currency despite the fact that there was no foreign exchange transaction during the year. (iii) Economic Exposure: Economic exposure measures the probability that fluctuations in foreign exchange rate will affect the value of the firm. The intrinsic value of a firm is calculated by discounting the expected future cash flows with appropriate discounting rate. The risk involved in economic exposure requires measurement of the effect of fluctuations in exchange rate on different future cash flows.


All the rest numerical were done in lecture, refer practice problem series..........