CHAPTER 11
FOREIGN CURRENCY DERIVATIVES
Hedging Foreign Exchange Exposure through Derivatives
Question 1
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following information
is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
a) forward contract;
b) money market hedge;
c) an option contract;
d) no hedging Show calculations in each case.
Ans: (a) $588,000 (b) $ 602,934 (c) $595,230 (d) no hedging = $586,500
Question 2
Best of Luck Ltd, London will have to make a payment of $ 3,64,897 in six months’ time. It is
currently 1st October. The company is considering the various choices it has in order to hedge its
transaction exposure.
Exchange rates
Spot rate $ 1.5617 - 1.5773
Six-months forward rate $ 1.5455 - 1.5609
Borrow (%) Deposit (%)
US 6 4.5
UK 7 5.5
Foreign currency option prices (1 unit is £ 12,500):
Exercise Price Call option (March) Put option (March)
$1.70 / £ $0.037 $ 0.096
By making the appropriate calculations and ignoring time value of money (in case of premium)
decide which of the following hedging alternatives is the most attractive to best of luck ltd.
i) Forward market
ii) Cash (money market)
iii) Currency options.
Ans: (i) £236,103 (ii) £236,510 (iii) £227,923 (Assumption:17 contracts)
Question 3
ABC Textiles Ltd. places an order to buy textile machinery with an American Company. As per
the agreement, ABC Textiles Ltd. will be paying US $ 200,000 after 180 days. As the fluctuation
in the spot rate of US $ over next 180 days will impact the rupee cost of import, the Board of ABC
Textiles Ltd. asks its finance manager to collect data from the currency forward market, money
market, currency option market, etc. The board also asks a consultant to assess various possible
dollar spot rates after six months.
The various findings are as follows:
• Possible spot rate of US dollar after six months, as estimated by the consultant, is Rs. 75.60,
Rs. 76.40, Rs. 76.80, Rs. 77.60 and Rs. 78.24.
• Spot rate of US dollar as of today is Rs. 76.80 per dollar.
• 180 days’ forward rate of dollar as of today is Rs. 77.57 per dollar.
• Interest rates prevailing in two countries are as follows:
Nepal USA
For 180 days deposit (per annum) 7.5% 1.5%
For 180 days borrowing (per annum) 8.0% 2.0%
• A call option on the dollar, which expires in 180 days, has an exercise price of Rs. 76.80 per
dollar and premium of Rs. 0.83 per dollar.
• A put option on the dollar, which expires in 180 days, has an exercise price of Rs. 76.80 per
dollar and premium of Rs. 0.64 per dollar.
You are required to carry out a comparative analysis of the various outcomes (Rupee cost of
import) under the alternatives:
i) Not hedging,
ii) Forward hedging,
iii) Money market hedging, and
iv) Option hedging.
Ans: (i) Rs. 1,56,48,000 (Max) (ii) Rs. 1,55,14,000 (iii) Rs. 1,58,55,471 (iv) Up to 1,55,32,640
(ignoring TVM on premium)
Question 4
A British firm will have following two cash transactions after 2 months:
Cash payment for purchase of machinery: $ 5,14,000
Cash receipt of dividend income: $ 1,10,000
Exchange data
Spot rate 1£= $1.6000/1.6050
2 months forward 10/11 cent
Interest rates (Pound) 12% per annum
Two months maturity Option data (lot size £ 25,000)
Strike Price ($/£) Call Put
1.55 1 cent 1.2 cents
1.60 1.2 cents 1.3 cents
1.65 1.3 cents 1.4 cents
1.70 1.4 cents 1.60 cents
1.75 1.5 cents 1.75 cents
Using the data given above, you are required to suggest the model of foreign exchange risk
management.
Ans: Forward £ 2,37,647; Option £ 2,33,539
Question 5
XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30th June. In order to
hedge the risk involved in foreign currency transaction, the firm is considering two alternative
methods i.e. forward market cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.9516/1.9711. 1.9726./1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate. You are
required to recommend cheaper hedging alternative for XYZ.
Ans: Rs. 2,53,473 ;Rs.2,47,109
Question 6
An American firm is under obligation to pay interests of Can$ 10,10,000 and Can$ 7,05,000 on
31st July and 30th September respectively. The Firm is risk averse and its policy is to hedge the
risks involved in all foreign currency transactions. The Finance Manager of the firm is thinking of
hedging the risk considering two methods i.e. fixed forward or option contracts.
It is now June 30. Following quotations regarding rates of exchange, US$ per Can$, from the
firm’s bank were obtained:
Spot 1 Month Forward 3 Months Forward
0.9284-0.9288 0.9301 0.9356
Price for a Can$ /US$ option on a U.S. stock exchange (cents per Can$, payable on purchase of
the option, contract size Can$ 50,000) are as follows:
Strike Price Calls Puts
(US$/Can$) July Sept. July Sept.
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the suggestion of finance manager if options are to be used, one month option should
be bought at a strike price of 94 cents and three month option at a strike price of 95 cents and for
the remainder uncovered by the options the firm would bear the risk itself. For this, it would use
forward rate as the best estimate of spot. Transaction costs are ignored.
Recommend, which of the above two methods would be appropriate for the American firm to
hedge its foreign exchange risk on the two interest payments.
Ans: July - Option $ 959,501 , Forward $939,401; September – Option -$ 681,158 ;
Forward $659,598
Question 7
You plan to visit Geneva, Switzerland in about 3 months to attend an international financial
conference. You expect to incur the total cost of SF 5,000 for lodging, fooding and transportation
during your stay. As of today, the spot exchange rate is $0.60 / SF and the three-month forward
rate is $0.63 / SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF
for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same
as the forward rate. The three - month interest rate is 6% p.a. in the US and 4% p.a. in Switzerland.
(i) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option
on SF.
(ii) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a
forward contract.
(iii) At what future spot exchange rate will you be indifferent between the forward and option
market hedges?
(iv) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange
rate under both the options and forward market hedges.
Ans: (i) $3,403.75 (ii) $3,150 (iii) $ 0.57925/SF (iv) Fixed $ 3,150 vs. Max. $3,453.75
Question 8
Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4 million
with a large German retailer on 6 months credit. If successful, this will be the first time that
Nitrogen Ltd has exported goods into the highly competitive German market. The following three
alternatives are being considered for managing the transaction risk before the order is finalized.
i) Invoice the German firm in Sterling using the current exchange rate to calculate the invoice
amount.
ii) Alternative of invoicing the German firm in € and using a forward foreign exchange contract
to hedge the transaction risk.
iii) Invoice the German first in € and use sufficient 6 months sterling future contracts (to the nearly
whole number) to hedge the transaction risk.
Following data is available:
Spot Rate € 1.1750 - €1.1770/£
6 months forward premium 0.60-0.55 Euro Cents
6 months future contract is currently trading at €1.1760/£
6 months future contract size is £62,500
Spot rate and 6 months future rate €1.1785/£
Required:
a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three proposals.
b) In your opinion, which alternative would you consider to be the most appropriate and the reason
thereof.
Ans: (a) £3,398,471; £ 3,414,426; € 3,401,305 (b) Forward Contract
Question 9
Zaz plc, a UK Company is in the process of negotiating an order amounting € 2.8 million with a
large German retailer on 6 months’ credit. If successful, this will be first time for Zaz has exported
goods into the highly competitive German Market. The Zaz is considering following 3 alternatives
for managing the transaction risk before the order is finalized.
a) Mr. Peter the Marketing head has suggested that in order to remove transaction risk completely
Zaz should invoice the German firm in Sterling using the current €/£ average spot rate to
calculate the invoice amount.
b) Mr. Wilson, CE is doubtful about Mr. Peter’s proposal and suggested an alternative of invoicing
the German firm in € and using a forward exchange contract to hedge the transaction risk.
c) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the German first in €, but
she is of opinion that Zaz. should use sufficient 6 months sterling future contracts (to the nearest
whole number) to hedge the transaction risk.
Following data is available
Spot Rate € 1.1960 - €1.1970 /£
6 months forward premium 0.60 – 0.55 Euro Cents.
6 months future contract is currently trading at € 1.1943/£
6 months future contract size is £ 62,500
After 6 months Spot rate and future rate € 1.1873/£
You are required to:
a) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3 above proposals.
b) In your opinion which alternative you consider to be most appropriate.
Ans: (a) £ 23,40,159; £ 23,49,979; £ 23,44,290 (b) Forward Contract
Question 10
XYZ Ltd. is an export-oriented business house based in Mumbai. The Company invoices in
customers’ currency. Its receipt of US $ 1,00,000 is due on September 1, 2005. Market information
as at June 1, 2005.
Exchange Rates Currency Futures
US $ /Rs. US $ /Rs. Contract size Rs. 4,72,000
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118
3 Months Forward 0.02127
Initial Margin Interest Rates in India
June Rs. 10,000 7.50%
September Rs. 15,000 8.00%
On September 1, 2005 the spot rate US $/Re. is 0.02133 and currency future rate is 0.02134.
Comment, which of the following methods would be most advantageous for XYZ Ltd?
a) Using forward contract
b) Using currency futures
c) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the futures contract.
Ans: (a) Rs. 47,01,457 (b) Rs. 47,20,639 (c) Rs. 46,88,233
