FM201 - Financial Institutions & Markets

Tutorial 10 Solutions

Chapter 16

1. Briefly outline the basic contention of the purchasing power parity theory of exchange rate determination.
• PPP theory contends that exchange rates, in a floating exchange rate regime, will adjust to ensure prices on
the same goods and services are equal between countries.
• The PPP theory has been used to determine whether or not various currencies are appropriately valued in
FX markets; for example, under PPP if the price of a product in the UK increases by 3%, but the price
remains unchanged in New Zealand, the NZD should appreciate by 3%. If the NZD did not appreciate by
that amount it is undervalued, and market participants would expect it to appreciate.
• While PPP sounds rational, in practice PPP, as a theory of exchange rate determination, provides reasonable
results only in the long run.
• PPP does not appear to be very useful in explaining movements in exchange rates where the periods under
consideration are as short as a few months or even a few years.

Chapter 17

2. Define FX risk, paying particular attention to transaction, translation, operating and economic
exposures. In your answer use an example to demonstrate each of the FX exposures.
• FX risk—the risk that receivables, payables, assets or liabilities that are denominated in foreign currencies
will change in value if the exchange rate between the local currency and the foreign currency changes into
the future.
• FX risk exposures can be classified in terms of its impact on a firm’s cash flows, balance sheet, competitive
position and net value.
• FX risk is defined as comprising transaction exposure, translation or accounting exposure, operational
exposure, and economic exposure.
• Transaction exposure refers to the extent to which a firm's future cash flows may be affected in value by
changes in the exchange rate; for example, a firm that has entered into a contract to import goods from
overseas with a contract that denominated in a foreign currency, say USD, is exposed to transaction risk.
If the importer’s local currency depreciates before payment is made, it will cost more of the local currency
to purchase the same quantity of USD to pay for the imported goods.
• Translation exposure or accounting exposure measures the impact of exchange rate changes on the
consolidated financial statements of a firm; for example, if a company accumulates assets or liabilities
overseas, these items will be denominated in a foreign currency. If the company translates the value of
those assets and liabilities onto its consolidated balance sheet at anything other than the original exchange
 FM201 - Financial Institutions & Markets
Tutorial 10 Solutions

rate, the value of the assets or liabilities in local currency terms will be affected by fluctuations in the
exchange rate.
• Need to consider local accounting standards (variations to international accounting standards).
• Operating FX exposure measures the extent to which exchange rate volatility may affect a firm’s future
operating cash flows; for example, a company that has a foreign subsidiary must pay its employees and
day-to-day operating expenses in the currency of the foreign operation. However, funds may be provided
from the parent company in its local currency.
• Economic FX exposure, is a broad measure that attempts to capture the impact of unexpected exchange
rate fluctuations on the net present value of the firm's future cash flows, that is, the future value of a firm;
for example, the value of an exporting company is the present value of its future cash flows. A change in
the exchange rate may adversely affect the cash flows and therefore the present value of the company. The
share price may fall.
3. An Australian company is exporting electronic components to Sweden. The company has a receivable
of SEK10 000 000 (Swedish Krona) due in three months’ time. The company approaches its bank and
enters into a forward exchange contract. Rates are quoted as AUD/SEK6.16-19, forward points 8–5.
Discuss the transactions that will take place today and in three months’ time. Show your calculations.
• The calculation of forward exchange rate was covered in Chapter 15; it is appropriate to be able to apply
that knowledge now.
• The dealer has quoted the spot rate AUD/SEK6.16-19 plus given the forward points for the three-month
forward exchange contract (8-5 points).
• The forward rate is AUD/SEK6.08-14 (note: as the points are falling they are subtracted from the spot rate).
• The company enters into a contract to buy AUD (sell SEK) three months forward.
• The contract rate is the dealer’s three month forward offer rate, that is, AUD/SEK6.14
• The dealer will sell AUD1 for each SEK6.14
• In six months the company will supply SEK10 000 000 to the dealer and will receive $1,628,664.50

4. Explain how an Australian company could hedge its net HUF (Hungarian Forint) payables using a
BSI money-market hedging strategy. Illustrate your answer based on the company having a HUF200
million payable due in 180 days. Assume a spot rate of AUD/HUF206.90-99, a Hungarian interest
rate of 8.00 per cent per annum and an Australian interest rate of 4.50 per cent per annum.
• BSI = Borrow, Spot, Invest
 FM201 - Financial Institutions & Markets
Tutorial 10 Solutions

• The general principle behind the strategy is to create a position opposite to the original situation that is
exposed to risk.
• The Australian company has a HUF200 million payable in six months' time. With a money market hedge
the exposure could be covered by:
o borrowing AUD today sufficient to purchase HUF that can be invested in Hungary and will be worth
HUF200million in 180 days
o converting the AUD into HUF at the spot rate
o investing the HUF today in the Hungarian money markets for 180 days
o repaying the AUD loan in six months and paying HUF payable with HUF investment due.

Transactions
Today:
• the company borrows AUD929 471.69 at 4.5% p.a.; that is, in 180 days it will repay AUD929
471.69 x [1 + (0.045 x 180/365)] = AUD950 384.80
• the company buys HUF with the AUD, at the dealer's spot bid rate; that is, AUD929 471.69
x 206.90 = HUF192 307 692.30
• the company invests HUF for 180 days at 8% p.a.; that is, in 180 days it will receive HUF192
307 692.30 x [1 + (0.08 x 180/360)] = HUF200 million. [note: it is best to start at this point
and work backwards]
In 180 days:
• the company makes its HUF200 million payable for its commercial transaction.
• the company receives HUF200 million from its Hungarian money market investment.
• the company retires its AUD debt with its AUD funds.

• Had the company not taken this cover the value of its HUF payable, in terms of the amount of AUD in 180
days, would be uncertain. It would depend on the spot AUD/HUF rate at that time. Having hedged using
the BSI strategy, the company is assured today that it will receive HUF 200 million in 180 days to meet its
HUF payable.
 FM201 - Financial Institutions & Markets
Tutorial 10 Solutions

206.9 buy
206.99 sell

200,000,000.00
192,307,692.31 pv
929,471.69 sell AUD @206.9

929,471.69 borrow AUD

192,307,692.31 convert @ spot 206.9
192,307,692.31 invest in Hungary for 180 days @ 8% pa.

after 6 months
200,000,000.00 value of 192,307,692.31 @ 4% (6mnths)
retire AUD debt with AUD funds.

5. Liverpool plc must make a payment of US $450,000 in 3 months’ time. The company treasurer has
determined the following:
Spot rate – $1.7000 – $1.7040
3 months forward – $1.6902 – $1.6944
6 months forward – $1.6764 – $1.6809

Money Market rates: Borrowing (p.a.) Deposit (p.a.)

US dollars 6.5% 5%

Sterling 7.5% 6%

Decide whether a forward contract hedge or a money market hedge should be undertaken.
 FM201 - Financial Institutions & Markets
Tutorial 10 Solutions

Using Money Market Hedge:

GBP USD
Today
Borrow PV of $450,000
450,000*(1.0125^-1) 444,444.44 a

Spot convert @ 1.7000 (261,437.91) b

Invest USD @ 1.25% 444,444.44 c

3 months
USD interest received 5,555.56 d

GBP interest payable (4,901.96) e

Total USD Deposit 450,000.00 = c + d

Total GBP Borrowing (266,339.87) =b+e
Withdraw USD Deposit & pay client (450,000.00)
(266,339.87) - =b+e

Using Forward Contract:

Forward rate that will be given by the dealer = 1.6902

450,000
1.6902

Total payable under forward contract = (266,240.68)

Therefore, it is better to use Forward Contract to hedge this exposure as

payable would be GBP99.19 less (266,339.87 - 266,240.68).

6. Bolton is now to receive US $400,000 in 3 months’ time. The company treasurer has determined the
following:
Spot rate – $1.8250 – $1.8361
3 months forward points– 0.88¢ - 0.91¢

Money Market rates: Borrowing (p.a.) Deposit (p.a.)

US dollars 5.1% 4.2%
Sterling 5.75% 4.5%

Decide whether a forward contract hedge or a money market hedge should be undertaken.
 FM201 - Financial Institutions & Markets
Tutorial 10 Solutions

Using Money Market Hedge

GBP USD
Today
Borrow PV of $400,000
400,000*(1.01275^-1) (394,964.21) a

Spot convert @ 1.8361 215,110.40 b

Invest GBP @ 1.125% 215,110.40 c

3 months
GBP interest received 2,419.99 d

USD interest payable (5,035.79) e

Total FJD Received 217,530.39 =c+d

Total USD Borrowing (400,000.00) = a + e

Receive $400,000 from client and pay 400,000.00

217,530.39 - =c+d

Using Forward Contract:

Forward rate that will be given by the dealer = 1.8452 = (1.8361 + .0091)

400,000
1.8452

Total received under forward contract = 216,778.67

Therefore, it is better to use MMH to hedge this exposure as amount received

would be more.