Risk managment A company produces locally and sells in a foreign currency, where
ID: 1171662 • Letter: R
Question
Risk managment
A company produces locally and sells in a foreign currency, where x denotes the ex- change rate. The sales in foreign currency over the next year are expected to be 5,000, that will be converted to local currency at the end of the year. The company’s costs for next year are expected to be 95,000. Thus, the company’s revenues in local currency at the end of the year are given by
R = 5,000·x1 ?95,000
where x1 is the exchange rate at the end of the year. There exist a forward contract on the foreign currency with maturity one year. The local interest rate is r = 5% per year.
Case 1: The foreign interest rate is rf = 7% per year and the current exchange rate is x0 = 21.4.
(a) Explain why the forward price should be 21.0.
(b) How can the company hedge using the forward contract and what would the company’s revenues be in this case, given the forward price in (a)?
(c) How should the company hedge if the forward price is 20, providing all of the company’s transactions?
(d) Compute the present value of the company’s next year revenues in the absence of any market frictions, if the company decides not to hedge. Show all necessary explanations for your computations.
Explanation / Answer
Case 1: Spot rate= 21.4 r= 5% rf= 7% Answer (a) forward rate= (1+r/1+rf)*spor rate = (1.05/1.07)*21.4 = 21 Thus forward rate should be 21. So, that there is no chances for arbitrage gain Answer(b) If company hedge using forward rate. Than, company agreed to convert the foreign currency at the rate of 21 Thus x1=21 Revenue= 5000*21-95000 = 10000 Answer ( c) If forward rate=20 Then Revenue= 5000*20-95000 = 5000 Answer(D) If company decide not to hedge Spot rate at the end of current yr= 21 r= 5% rf= 7% Expected rate= (1+r/1+rf)*spor rate = 20.60748 Then Revenue= 5000*20.60748-95000 = 8037.4 Present value of revenue= Revenue/(1+r%) = 7654.667
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