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(Solved by Expert Tutors)International Finance Problem Set on FX Transaction Exposure

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International Finance Problem Set on FX Transaction Exposure

1.On May 1st, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for ?4,000,000, payable on August 1st. ?Larkin derived its price quote of ?4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of? $1.0800/?.?

Four approaches are possible:

1.? Hedge in the forward market. The 3-month forward exchange quote was $1.1060/?.

2.? Hedge in the money market. Larkin could borrow euros in the Libor market at 8% per annum and invest in ? at 5% p.a.?? In the USD Libor market the firm can borrow at 7% p.a. and invest at 4% p.a.

3.? Hedge with foreign currency options. ?August put options were available at strike price of $1.1000/? for a premium of 2.0% per contract. ?August call options with a strike at $1.1000/? could be purchased for a premium of 3.0%.

4.? Do nothing. Larkin could wait until the sales proceeds were received in August and sell the euros received for dollars in the spot market.

Larkin estimates the cost of equity capital to be 12% per annum.? What should Larkin do?

2. Hensley Manufacturing Co. has purchased a robotic welding machine from a Japanese firm for ?8 million and has to make payment in 60 days.? The current spot exchange rate is ?110.40/$ and the 60 day forward rate is ?109.36/$.? The corporate treasurer expects the yen to be at ?115/$ in 60 days.? Interest rates available to the firm are (invest/borrow) 2.6/4.2% p.a. in USD and 1.1/3.2% p.a. in Yen.? The WACC for the firm is 12% p.a.? The Treasurer is also considering using FX options to hedge this A/P.? Call options with a strike of ?110/$ and a premium of 3% and put options with a strike of ?110/$ and a premium of 4% are available from the firm?s bank.? Calculate the expected cost of the unhedged, forward contract, money market, and option hedges and make a recommendation.

 


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