Problem Set #10
1) Suppose that you ran the following regression:
%Change in Cash Flows ($) = a + b (%change in exchange rate)
You get the following results (T-Stats in Parentheses)
a = .10 (.67)
b = 2.56 (7.45)
How could you hedge this risk in the options market?
2) What is the difference between transaction exposure and translation exposure? Many argue that it is unnecessary to hedge translation exposure. Why is this?
3) Explain the following statement: “If Purchasing Power Parity holds in the long run, then hedging currency exposure is unnecessary”.
4) You are expecting a bill denominated in Euros in 3 months. You want to hedge your risk of a dollar depreciation, but would also like to capitalize off the possibility of a dollar appreciation. You are considering two strategies:
a) Purchasing a call option on Euros with a strike price of $1.30. The premium on this option is $.06 per pound.
b) Hedging only 1/2 of the cost with a forward contract (forward price = $1.30)
Within what range for the future exchange rate are you better off using the partial hedge?
5) Suppose that you have revenues denominated in Japanese Yen expected in 6 months. How would you hedge this risk using money market instruments? How would a money market hedge compare to a forward hedge?