finc415 exam 2

Steps for money market Hedge A/R

$/ pound 1. Borrow 1 pound, in one year repay 1 pound (1 + interst) 2. Convert spot 1 pound * spot rate = $Spot 3. Invest $Spot at $i, receive S * (S + i) 4. Buy pounds forward to repay loan in step 1, repay F * (1+i pounds) look at equation 7-20

Assuming Maria can invest the $1,720,976 in the firm at the WACC (iWACC = 12% pa), how much will Maria have in three months?

$1,720,976 / (1 + 12%/4) = $1,772,605 Maria has turned her £1,000,000 receivable into a $1,772,605 receivable we know it cants be anything less than $1,720,976 bc this is how much she invested and this would mea we would have a negative investment.

Transaction exposure measures ____

*gains or losses* that arise from the *settlement* of existing financial obligations whose terms are stated in a *foreign currency.*

A/R MM Hedge steps expanded use recievable to repay foreign loan

1. Borrow at X £, repay X £ * (1+ i £) 2. convert spot: buy $ spot: X£ * Spot$/£ = XS$ 3. invest X * S at i$, receive X*S*(1+i$) so how much should we borrow? How much is X? borrow the PV of the receivable! X= Receivable£/ (1+i£) this way your repayment amount will exactly equal your foreign A/R

A/R MM Hedge steps

1. Borrow foreign (borrow present value of foreign receivable) (i have a + in FC, want a -, so borrow) - *use A/R to repay foreign loan* 2. convert spot (sell FC, buy $) 3. Invest $at WACC -- turns your foreign receivable into a $ receivable

DETERMINING WHICH ALTERNATIVE TO UNDERTAKE Ganado, like all firms, must decide on a strategy to undertake before the exchange rate changes, but how will Maria choose among the strategies? Two criteria can be utilized to help Maria choose her strategy:

1. RISK TOLERANCE: of the firm, as expressed in stated policies and 2. VIEWPOINT: Marias own view on the expected direction and distance of the exchange rate After all the strategies have been explained, Ganado now needs to compare the alternatives and their outcomes in order to choose a strategy. There were four alternatives available to manage this account receivable, and Maria has a budget rate at which she cannot fall below on this transaction.

how to do a money market hedge? First 3 steps of covered Interest Arbitrage

1. borrow 2. convert spot 3. invest

A/P MM Hedge steps

1. borrow dollars - turn your FC payable into a $ payable (i have a - in FC, want a +, invest to offset FC) 2. convert spot (sell $ buy FC) 3. invest foreign at WACC (invest present value of foreign payable) - *use proceeds to pay A/P*

4 alternatives used to manage exposure:

1. remain unhedged (intentionally taking E/R risk) 2. hedge in forward market (simplest way to hedge) 3. hedge in money market (will need I/R) 4. hedge in the options market

Assume that Ganado has a £1,000,000 account payable due in 90 days. Remain unhedged - Ganado could wait the 90 days and at that time exchange dollars for pounds to pay the obligation. - This alternative is risky, as it depends on the future spot rate. Forward hedge - Maria could use a forward hedge and pay $1,754,000 for sure (assume F = $1.754/£). Money market hedge - Although the steps are the same (borrow, convert spot, invest), for a FC payable, you must borrow $, invest foreign. (have - in FC, want a + in FC) - Here, Ganado would exchange U.S. dollars spot and invest them for 90 days in pounds. - The pound obligation for Ganado is now offset by the pound investment.

2 OPTIONS

Genado Example Maria Gonzalez is the chief financial officer of Ganado, a U.S.-based maker of telecommunications equipment. She has just concluded negotiations for the sale of telecommunications equipment to Regency, a British firm, for £1,000,000. (A/R + inflow) The sale is made in March, with payment due three months later in June. Maria has collected the following financial and market information for the analysis of her currency exposure problem: Spot exchange rate: S0 = $1.7640/£ 3-month forward rate: F0,3 = $1.7540/£ Ganado's cost of capital: WACC = 12.0% Interest Rates (% p.a., compounded quarterly): (/4) •U.K. 3-month borrowing rate: i£,Borrow = 10.0% •U.K. 3-month investment rate: i£,Invest = 8.0% •U.S. 3-month borrowing rate: i$,Borrow = 8.0% •U.S. 3-month investment rate: i$,Invest = 6.0% Financial and market information (cont.): June put option in the for £1,000,000; strike price $1.75/£); 1.5% premium. - •"The right, but mot the obligation to sell 1M pounds for $1.75/£" Ganado's foreign exchange advisory service forecasts that the spot rate in three months will be $1.76/£ (i.e., E0[S3] = $1.76/£).

Although Ms. Gonzales and Ganado would be very happy if the pound appreciated versus the dollar, concerns center on the possibility that the pound will fall. (downside risk) When Ms. Gonzales budgeted this specific contract, she determined that its minimum acceptable margin was at a sales price of $1,700,000. - *In other words, we need to turn this 1M pounds into atleast 1.7M dollars, if not we are losing money on this deal*

Ap/P MM Hedge

Although the steps to conduct a MM hedge for a payable are done in the following order: 1.Borrow dollars *turns your foreign payable into a $ payable* 2.Convert spot (sell $, buy foreign currency) 3.Invest foreign (invest presentvalue of foreign payable)(use proceeds to pay A/P) I find it's easier to solve these backwards. For a £1m payable, you hedge by investing the PV of the £1m payable: where S0= $1.7640/£iWACC = 12% p.a.i£,invest = 8% p.a 3. Invest the PV of the payable: 1M pounds / (1+8%/2) = £980,392 2. Convert spot (sell $, buy FC) £980,392*$1.7640/£= $1,729,412 3. Borrow $: Borrow $1,729,412 In 3 mo, repay the $ loan at iWACC: ($1,729,412)×(1+12%/4) = $1,781,294 This is your net cost with MM hedge

if you were to hold everything constant, you'd pay for the ____ option bc it has flexibility so that you can exercise it at any point.

American

almost all options are done in terms of american or european quotes?

American quotes ($/FC)

How much should Maria borrow to cover the £1,000,000 receivable due in 3 months? (i£,borrow = 10% p.a.)

Borrow the PV of the recievalbe £1,000,000 / (1 + 10%/4) = £975,610 We want to borrow exactly enough that you owe in terms of principle and interest exactly the 1M £

Maria has finished step 1: she borrowed £975,610. Maria now has £975,610. What should she do with it? S0 = $1.7640/£, F0,3 = $1.7540/£

Convert spot @ $1.7640/£: Sell £975,610, buy $1,720,976. £975,610 * $1.764/£ = $1,720,976 Now that we have converted the £ to dollars we have eliminated all E/R risk because we know we have the £1M receivable that will cover our loan

Recap:

Ganado will, thus, receive £1,000,000 in 3 months. Ganado would like to trade these British pounds for dollars. Tt would like to enter into a contract today such that Ganado can be sure how many dollars it will receive in return for those £1,000,0000.

Ganado has a £1,000,000 receivable, due in 3 months. To hedge in the money market, what should Ganado do?

Foreign receivable à borrow foreign I have a + in FC. I want to create - in FC by borrowing the FC a.Borrow £, sell £ (buy $) spot, invest $.

As can be seen from the graph, the Forward hedge will cost a certain $1,754,000, while the money market hedge will cost a certain $1,781,294. Which contract is preferable?

Forward contract, take less dollars out of pocket

an option whose exercise/strike price = spot price of the underlying currency is:

at the money S=X moneyness (ignore the price. cost of the option regardless of at the money, in the money, out of the money)

hedging means taking the ____ position, so if you have a foreign receivable, borrow foreign

opposite

how IRP is same as covered IRP

IRP states F/ S = change in I/R can rewrite as F = S * change in I/R

Examples where inflows or outflows may be uncertain include the following:

International tenders Foreign exchange accounts receivable with substantial default risk à may not get money paid to you Risky portfolio investment

Maria's finished steps 1 and 2. She borrowed £975,610, converted spot to $1,720,976. Now what should she do?Invest

Invest $1,720,976 for 3 months.

A firm that faces a future outflow of SF might buy a call option on SF with strike price X. The ensuing right to buy SF at X means that this firm will pay no more than X per SF (we might pay less) Thus, when hedging, buying a call is like taking out an insurance contract against the risk of high exchange rates. (sets ceiling)

Likewise, a firm that expects to receive future SF might (downside: FC dec) acquire a put option on SF. The right to sell at X ensures that this firm gets no less than X for its SF. Thus, when hedging, buying a put is like taking out an insurance contract against the risk of low exchange rates. (sets floor)

????FINDING BREAKEVEN POINT BETWEEN FORWARD AND MARKET HEDGE At what $ rate would Ganado be indifferent between the forward and market hedge?

Loan proceeds * (1 + I/R) = Forward Rates Loan proceeds are found by converting spot. Borrowing amount * spot rate $1,720,976 * (1 + i$/4) = $1,754,000 i$, breakeven= (1.92%)*4=7.68%p.a As long as Ganado can earn at least 7.68% on the investment, the money market hedge will be better than the forward hedge.

A/R: As can be seen from the graph, the Forward hedge yields a certain $1,754,000, while the money market hedge yields a certain $1,772,605.

MM Hedge You want to put the most amount of money in your pocket as possible. Therefore, you want to choose the money market hedge because it gives you the most money.

Which of the following statements is true when you are hedging with options?

Put option provides insurance against low E/R Call option provides insurance against high E/R If you need to buy FC, you want it to be low so the call option sets the value and the call option provides insurance against high E/R When you sell FC, you want this # to be high. Therefore the put option sets the floor for you and you know you'll get at least this amount. Then if it goes higher, you're going to not exercise and benefit from the increased price

on the expiration date, a call option is worth:

S - X if the FC is worth more than X 0, otherwise

Forward purchase =

S = X

when is there no arbitrage condition?

S(1+i $) = F (1 + i $) "you should not earn profit, moenymarket hedge should cost the same as the forward hedge* investment amount = repayment amount In efficient markets, IRP should ensure that these costs are nearly the same, but not all market are efficient at all times. Thus, it's possible that, for any particular firm, the MM hedge may be preferable to the forward (or vice versa).

For a MM hedge, do you borrow domestic or forieng? depends on whether youre hedging an ___ or ___

That depends on whether you're hedging an Account Payable or Receivable (in a foreign currency). if you have a foreign receivable, you BORROW foreign ( I have a + in FC, want to create a -, so i borrow FC to offset) if you have a foreign payable, you invest foreign ( i have a - in FC, and want to create a + in FC, i invest to offset)

Example: Suppose Superstuff, a U.S. company, has issued SF-denominated promissory notes (so they will need to buy foreign exchange). (outflow exposure to FC ,we are paying money, not receiving it)

The company wishes to hedge itself and thus, buys a call on SF at X = $0.60/SF expiring at the same date, T, as the promissory notes. Then, the dollar cost of paying back the SF debt cannot be higher than $0.60/SF, but it might be lower. RISK: we dont know FC will be when we buy. we want to choose the option that lets us buy the FC which is the option premium If at time T the SF trades above $0.60, Superstuff will exercise its call option and buy SF at $0.60. If ST < $0.60/SF, Superstuff simply buys its SF in the spot market, and lets the call expire unexercised. we are taking advantage of the lower price By contrast, if Superstuff had used a forward contract to purchase Ft,T = $0.60/SF, then it could not benefit from a possible lower value of the SF.

Option 1: Unhedged position

This means the recievable will be worth 1,000,000 pounds * Spot rate in June Amount is UNCERTAIN she is accepting the transaction risk

Example: Suppose instead that Superstuff holds SF assets, such as a SF receivable (so they will need to sell foreign exchange). (we have inflow exposure to FC, so we'll need to sell FC -- we'll buy a put bc this allows us to sell FC)

To hedge itself, the firm buys a put on SF at X=$0.60/SF expiring at the same date, T, as the SF asset. Then the $US proceeds from selling the SF cannot be lower than $0.60/SF, but they might be higher. (we may beable to benefit from the currency moving in our favor) If at time T the SF trades below $0.60 (bad), Superstuff will exercise its put option and sell SF for $0.60. (this is better than 20 cents) If ST > $0.60/SF, Superstuff simply sells its SF in the spot market, and lets the put expire unexercised. By contrast, if Superstuff had used a forward contract to purchase Ft,T = $0.60/SF, then it could not benefit from a possible higher value of the SF.-- we're obligated to sell SF at 60 cents However, the forward purchase is free; the put is not. -- this is the trade off

What else must Maria do in 3 months?

Use the £1,000,000 she gets from Regency to repay the pound loan she took out. check: repay the loan: £975,610*(1 + 10%/4) = 1M pounds. 'Maria borrowed £975,610 3 mo ago at i of pounds = 10% p.a. she must repay £1M

A foreign currency contract allowing the holder the right to sell ¥1,000,000 on March 30th at a price of ¥105/$ is:

a.a put option on Japanese yen.

if IRP HOLDS you can:

borrow convert and invest money market hedge option

same features in a forward option and call option?

both a contract, price we agree to today, expiration date

background on call options

buyer will exercise this call option if the asset value goes above the strike price

Thus, the downside risk on a foreign currency outflow can be hedged by a ____.

call

what are the 2 basic types of options?

call and put

if a december call option = 57 cents/ FC what does this mean?

call option gives us right, but not the obligation to purchase 62,500 Swiss Franks for $35,625. (SF62,500 * $.57/SF) so if we exercise this option we can buy 62,500 SF for $35,625 with an expiration date of december how much does it cost to buy this option today? Cost of option * 62,500SF = .0174 *62500 = $1,087.5 if you buy 1 call option, it gives buyer right to purchase SF62,500 for $35,625 by paying $1.087.5- today. If you think the SF will go up to a $1/SF , this contract will give is right to buy for .57/SF and sell for $1/SF to make money. This is *speculating*

European option:

can be exercised only on the expiration date, not before.

foreign currency option:

contract giving the option purchaser (the buyer) the right, but not obligation, to buy or sell a given amount of foreign exchange at a fixed pricer per unit for a specified time period (until the expiration date)

whole point of a call option is that you must pay a premium at t=0 to eliminate downside risk

ok. look at charts on 6-9

we are looking at the FC option where the underlying asset is in the ____ and is the ___ exchange rate

denominator spot E/R

If Maria buys the put option, the amount she will have in 3 months depends on the future spot rate. Remember, the exercise price is X=$1.75/£. Suppose the spot rate in June is S3 = $1.80/£. What should Maria do?

dont exercise the option. sell all pounds in the spot market so we get more $

in risk management you are trying to minimize the ___ ___

downside risk

what are the 3 elements every option has?

exercise or strike price: E/R at which FC can be *purchased* (if you bought a call) or sold (if you bought a purchase) premium, cost, price, or value of the option itself (usually paid in advance by the buyer to the seller) This is HOW MUCH you pay for the option. underlying or actual spot E/R in the market you sell

Suppose the spot rate in June is S3 = $1.70/£. What should Maria do?

exercise the option Hedges downside!

why would you buy a forward contract over an option contract? why would you buy a call option vs aforward?

for a forward purchase you pay zero dollars today a call option allows you to obtain only the "nice part" (aka unlimited gain) of the forward purchase, and you pay no premium look at graph 6-11

One can also use options to hedge foreign currency cash flows that are not certain - that is, _____

foreign currency cash flows that are conditional on other events.

a forward hedge involves a ____ or futures contract and a ___ to fulfil the contract

forward contract source of funds funds will be available in June when Regency pays 1000000 pounds to Genado in 3 mo

difference between forward purchase and call option?

forward purchases dont have a right, only an obligation call option has contingent claim feature. forward does not

American option:

gives buyer the right to exercise the option at *anytime* between date of writing and expiration or maturity

any time you have risk management problems, think about where you have ______ outcomes

good and bad for a A/R its good when FC inc and bad when FC Dec

strategy choice and outcome chart

hedging strategy and outcome/ payout 1. remain unhedged - unkown 2. forward contract hedge @ $1.754/£ - $1,754,000 3. Money market hedge @ 12% p.a. $1,772,605 4. Put option hedge @ strike $1.75/£: Minimum if exercised $1,722,746 Maximum if not exercised Unlimited comes down to hedge in MM or hedge in options market

difference between hedging and speculating?

hedging: done to reduce risk speculating: intentionally taking on risk by ignoring the *forward rate*

the buyer of the option is the ____ and the seller of an option is the ____

holder writer/ grantor

Value of put option at expiration rules

if S < X, we will exercise put, therefore P = X - S, this is represented by diagonal line if S > X, we will not exercise, therefore P = 0, this is represented by flat line

Put option example

if put option is .60/ SF, the holder will only want to exercise this option if the spot price falls below .60/SF. if at maturity, S is above .60/ SF the option will go unexercised Value of put: P=max(x-S,0)

Rules around value of the call option at experiation

if spot rate < exercise price at expiration --> do not exercise the call option, C = 0 this means we could buy for $.60 and sell for $.40. and not profit if spot price > exercise price --> Exercise call option the profit would be S-X > 0 as spot price moves above exercise price, you gain cent for cent as you move along the diagonal line best case: you'd buy a call option by exercising because you have the opportunity to gain alot worst case: you dont exercise this option and lose all the money you initially invested

option that would be profitable is exercised immediately:

in the money

if you have an A/R, this is an inflow or outflow exposure to the FC? If you have A.R this is an ___ exposure to the FC

inflow (+) outflow (-)

explaining a call option graph

limited loss = flat line, where S < E unlimited loss = diagonal line, where S > E

"long to call" "short the call"

means you are the buyer/ owner of the option means you are the seller/ writer of the call and have an obligation to sell at a specified price

In each case, options are ____ flexible hedging devices than forwards and futures in the sense that the bidder *cannot* be forced to exercise.

more

forward put option:

obligation to sell at Spot

3 alternative to hedge is an option!

ok

option that would not be profitable if exercised immediately:

out of the money you would never exercise this bc you arent obligated to exercise it

background on put options

owner buys the put for the strike price the asset cost includes an option premium of the stock stays the same, the buyer is only out the option premium if the stock goes down, the buyer can exercise its put option

The _____ ____ allows us to easily make some risk management decisions

payoff diagram

like any insurance contract, the insured party will pay an insurance _________ to the insurer (the writer of the option)

premium price of an option is called option premium and acquiring an option contract is called buying a contract

put option:

right to sell at X with no obligation to do so

what is Transaction Exposure purpose?

risk management

In the above examples, we used options to hedge a _____ cash flow denominated in foreign currency.

risk-free

This is an account receivable, so Maria will need to _____ £ in 3 months. Thus, to hedge an A/R, use a ____ option to sell FC. The put option available has a strike price of $1.75/£. Unlike the forward contract, which is free, the put option costs money. It sells for a 1.5% premium. calculate the cost of the option:

sell put cost of option= size of the option * premium% * S0 = 1000000 pounds * 1.5% * ($1.7640/ pounds) = $26,460 *spot was higher than the strike/ exercise option so we used spot bc were selling*

money market hedge money market hedge is ___ to forward contract, in that it allows you to ____ hedge a foreign AR or AP Line ___ change depending on differing spot E/R

similar perfectly wont

strike = exercise price!

spot price is other price you can buy for

t or f: once we have converted the £ to dollars we have eliminated all E/R risk because we know we have the £1M receivable that will cover our loan

t

budget rate:

the lowest acceptable dollar per pound exchange rate ‑ was therefore established at $1.70/£. Any exchange rate below this budget rate would result in Ganado actually losing money on the transaction.

Forward purchase

the obligation to buy FC at a set cost

define a put option

the obligation to sell FC

define a call option

the option to buy FC

what are the 3 main types of Foreign Exchange Exposure?

transaction, operating, translation The exchange rate may affect the firm's cash flows and market value, either through its effect on existing contracts - Transaction Exposure or or through its impact on the future operating cash flows of the firm - Operating Exposure Exchange rate changes may have an impact on accounting values - This is called Accounting Exposure or Translation Exposure

*according to IRP: hedging in the forward market and hedging in the market should equal the hedge in the money market*

true

t or f : we will only exercise if we can buy low and sell high

true

t or f: options are derivative securities

true

t or f:we can hedge OR speculate with derivative securities

true

the risk associated with buying an option is ___ the same as the risk associated with selling the option

true

t or f: a put option allows you to obtain only the nice part of the forward sale

true look at 6-16

options derive their value from another ____ ____

underlying asset

Forward line is flat on the graph bc

we eliminated all FC E/R risk. we know regardless of the ending spot E/R we must sell at $1.754/pound

explaining an alternatives pay out graph

what does the kink mean in the put option? flat part of the line represents the floor differences between the unhedged line and put option line is: the FV of the put option forward hedge eliminates all uncertainty, the put option hedge limits downside risk but gives upside potential after we graphed MM hedge, put option hedge, forward and unhedge - which will you choose? choose between MM or put bc we already eliminated forward. there are 2 criteria

downside risk: upside risk:

when E/R moves against you when E/R increase/ decrease in your favor

whats the worst case scenario when you hedge with an option?

you must exercise it For example, if the spot rate in 3 months turns out to be $1.50/£, you'd rather exercise the put option and sell pounds at X=$1.75/£. If you exercise the put (at X=$1.75/£), you'll receive (minus the future value cost of the option): (£ receivable ∙ X$/£) - FV cost of put option = (£1,000,000×$1.75/£) - ($26,460×1.03) = $1,750,000 - $27,254 = $1,722,746 *always subtract FV cost of the option* $1,722,746 is the minimim youll receive (in S). worst case scenario is that you exercise the put.