Hedging Strategies in Finance

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Questions and Answers

What defines transaction exposure?

Long-term fluctuations in exchange rates that affect firm value

The impact of trade volumes on foreign exchange markets

Sensitivity of domestic currency values to exchange rate changes (correct)

Fixed-price contracts that are immune to exchange rate changes

At what future spot rate does the options hedge begin to dominate the money market hedge?

$1.4813/£ (correct)

$1.4812/£

$1.4820/£

$1.4800/£

What is the break-even spot rate at which Boeing is indifferent between the two hedging methods?

$1.4790/£

$1.4813/£ (correct)

$1.4825/£

$1.4800/£

Why is transaction exposure considered a short-term economic exposure?

It strictly relates to the timing of cash flow settlements Signup and view all the answers

How does transaction exposure primarily affect multinational corporations (MNCs)?

By introducing risks related to fixed-price contracts in foreign currencies Signup and view all the answers

What does the left side of the equation for break-even spot rate represent?

Dollar proceeds from the options hedge when exercised Signup and view all the answers

What is economic exposure primarily concerned with?

Unanticipated changes in exchange rates affecting firm value Signup and view all the answers

When is the money market hedge preferred over the options hedge?

When future spot rates are less than $1.4813/£ Signup and view all the answers

What differentiates transaction exposure from translation exposure?

Transaction exposure deals with fixed-price contracts while translation exposure deals with financial statements Signup and view all the answers

Which of the following best describes translation exposure?

The effect of currency changes on financial reporting Signup and view all the answers

What factors are considered in calculating the dollar proceeds of the options hedge?

Future spot rate and the option premium Signup and view all the answers

If the future spot rate is $1.4800/£, which hedging strategy is more advantageous?

Money market hedge Signup and view all the answers

What does it mean when it is said that economic exposure accounts for unanticipated changes?

Forecasted changes are already incorporated into valuation Signup and view all the answers

In what context is transaction exposure usually discussed?

It's discussed in relation to fixed-price contracts Signup and view all the answers

Which of the following equations represents the break-even point for the hedging methods?

$(10,000,000)S_T - $212,000 = $14,600,918$ Signup and view all the answers

What is a key characteristic of the options hedge compared to the money market hedge?

It provides flexibility in uncertain future conditions Signup and view all the answers

What does S represent in the equation S T > F?

The firm's expected spot exchange rate Signup and view all the answers

In the first scenario, what happens to the expected gains or losses when S is approximately equal to F?

Expected gains or losses are approximately zero Signup and view all the answers

What does forward hedging primarily eliminate for the firm?

Currency fluctuation risks Signup and view all the answers

Under what condition is the scenario where S is approximately equal to F considered valid?

When F is an unbiased predictor of S Signup and view all the answers

What is expected from the firm when S is less than F in the second scenario?

A positive gain from forward hedging Signup and view all the answers

What does the second scenario suggest about the firm's management perspective?

They dissent from the market's consensus forecast Signup and view all the answers

What is a potential motivational factor for the firm to hedge in the first scenario?

Avoidance of risk Signup and view all the answers

If a firm anticipates a future gain from forward hedging, what does that imply about the relationship between S and F?

S is less than F Signup and view all the answers

How much did Boeing need to borrow to match their pound receivable?

£9,174,312 Signup and view all the answers

What was the spot exchange rate used for converting pounds into dollars?

$1.50/£ Signup and view all the answers

What is the maturity value of the dollar investment after one year?

$14,600,918 Signup and view all the answers

What amount is Boeing expected to collect from British Airways after one year?

£10 million Signup and view all the answers

What does the net cash flow at the present time imply about the money market hedge?

It is fully self-financing. Signup and view all the answers

After borrowing the amount, what was the first action taken by Boeing?

Convert the pounds into dollars. Signup and view all the answers

What interest rate was assumed for the dollar investment in the United States?

6.1% Signup and view all the answers

What is the total amount that Boeing will repay at the end of the loan period?

£10 million Signup and view all the answers

What factor complicates the exact hedging process for firms using futures contracts?

The marking-to-market property Signup and view all the answers

Which statement accurately describes how a firm can hedge transaction exposure?

By matching assets and liabilities in the same currency Signup and view all the answers

How can a company like Boeing eliminate currency exchange exposure in foreign sales?

By borrowing in the foreign currency and converting it Signup and view all the answers

What must happen on the maturity date of a loan used for hedging?

The corresponding receivable must be used to pay off the loan Signup and view all the answers

What is one outcome of interim cash flows in a futures contract?

They could be invested at uncertain interest rates Signup and view all the answers

Which best describes a money market hedge?

Borrowing and lending in both domestic and foreign markets Signup and view all the answers

What is the primary reason for a firm to hedge transaction exposure?

To ensure steady cash flows and reduce risk Signup and view all the answers

What does a firm achieve by making the maturity value of a loan equal to its foreign receivable?

A zero net exposure in that foreign currency Signup and view all the answers

Study Notes

Money Market vs Options Hedge

The options hedge dominates the money market hedge for future spot rates greater than $1.4813/£
The money market hedge dominates the options hedge for future spot rates lower than $1.4813/£
Both hedging methods result in the same dollar proceeds at the break-even spot rate of $1.4813/£

Transaction Exposure

Transaction exposure is the sensitivity of a firm's realized domestic currency values of contractual cash flows to unexpected exchange rate changes.
This type of exposure affects the amount of money a firm owes or expects to receive in foreign currency, particularly for exporters and importers.
It is also considered a short-term economic exposure because it impacts the firm's domestic currency cash flows.
Transaction exposure arises from fixed-price contracting in a world with fluctuating exchange rates.

Forward Hedging

Forward hedging eliminates exchange exposure while potentially sacrificing expected dollar proceeds.
The forward exchange rate is an unbiased predictor of the future spot rate in most cases.
Hedging is beneficial when a company is risk-averse and expected dollar proceeds are approximately zero.
Under the second scenario, where the expected future spot exchange rate is less than the forward rate, the firm anticipates a positive gain from forward hedging.

Money Market Hedge

This strategy involves borrowing and lending in domestic and foreign money markets to hedge against transaction exposure.
Firms borrow in foreign currency to hedge receivables and lend in foreign currency to hedge payables.
In the example provided, Boeing borrows £9,174,312 at an interest rate of 9% to eliminate its pound exposure.
The borrowed amount is converted to dollars at the current spot rate and invested at a dollar interest rate of 6.1%.
The firm receives the maturity value of the dollar investment, ensuring the guaranteed dollar proceeds from the British sale.
This method is self-financing as the maturity value offsets the borrowed amount.

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Description

This quiz delves into the different hedging strategies such as options hedge and money market hedge, highlighting their effectiveness based on future spot rates. It also covers transaction exposure and forward hedging, illustrating how firms manage exchange rate fluctuations. Test your understanding of these critical financial concepts!