Finance 475

Problem Set #10

1) Given the following regression

            %Change in Cash Flows ($) =   .10   +    2.56 (%change in exchange rate)

We know that for every 1% depreciation of the dollar (i.e. the exchange rate increases), dollar cash flows increase.  Therefore, you are worried about dollar appreciations.  To profit from dollar appreciations, you would want to purchase put options on foreign currencies or call options on dollars.

2)      Transaction exposure refers to actual cash flows that are being converted back into a countries home currency while translation exposure is simply the conversion of balance sheet items into a common currency for reporting purposes. Since translation exposure refers to potential conversions of cash flows into a companyís home currency rather than actual cash flows, itís not clear why it would need to be hedged.

3)      If PPP holds (exchange rates adjust to account for differences in inflation), then cash flows in different countries are always equally valuable in terms of real purchasing power.

4) We need to solve the problem in two regions:

            For e > $1.30, the call option has value

            For e < $1.30, the call option is worthless

     For e > $1.30,

            Cost with call option = $1.30 + $.06 = $1.36

            Cost With Partial Hedge = (1/2)($1.30) + (1/2)(e)

                        $1.36 > (1/2)($1.30) + (1/2)(e)

                                    e < $1.42

     For e < $1.30,

            Cost with call option =e + $.06

            Cost With Partial Hedge = (1/2)($1.30) + (1/2)(e)

                        e + $.06 > (1/2)($1.30) + (1/2)(e)

                                    e > $1.18

5)  With expected revenue in Yen 6 months from now, consider the following options:

         Borrow Yen in the Japanese money market, convert to dollars using the current exchange rate, deposit the funds in the US money market.  When the loan comes due in Japan , use the Yen revenue to pay it off.

         Enter into a contract to sell Yen forward.

If covered interest parity holds (which it does!), both strategies will have the same payout.