International Financial Management 2017-2018
Tutorial 6 Solutions
Ch. 11. Management of Transaction Exposure
Ex. 5*, 8
Ch. 12. Management of Economic Exposure
Ex. 3*
Ch. 13. Management of Translation Exposure
Ex. 1*
Ch. 11. Management of Transaction Exposure
5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the
Swiss client a choice of paying either $10,000 or SF 15,000 in three months.
(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option
to buy up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?
(b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss
client will choose to use for payment? What is the value of this free option for the Swiss client?
(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?
Solution:
(a) The implied exercise (price) rate is: 10,000/15,000 = $0.6667/SF.
(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the
Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is
obviously SF1,129 (=SF16,129-SF15,000).
(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive
SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on
SF15,000.
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International Financial Management 2017-2018
Tutorial 6 Solutions
8. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect
the value of the pound to increase against the U.S. dollar over the next 30 days. You will be
making payment on a shipment of imported goods in 30 days and want to hedge your currency
exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5 percent. These
rates are expected to remain unchanged over the next month. The current spot rate is $1.50.
a. Indicate whether you should use a long or short forward contract to hedge currency risk.
b. Calculate the no-arbitrage price at which you could enter into a forward contract that expires
in three months.
c. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the
value of your forward position.
d. Using the text software spreadsheet TRANSEXP, replicate the analysis in Exhibit 8.8.
Solution:
a. The risk to you is that the value of the British pound will rise over the next 30 days and it
will require more U.S. dollars to buy the necessary pounds to make payment. To hedge this
risk, you should enter a forward contract to buy British pounds.
b. S0 = $1.50
T = 30/365
r = 0.055
rf = 0.045
 $1.50 
F (0, T )  
(1.055) 30 / 365  $1.5018
30 / 365 
(
1
.
045
)


c. St = $1.53
T = 30/365
t = 10/365
T – t = 20/365
r = 0.055
rf = 0.045
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International Financial Management 2017-2018
Tutorial 6 Solutions
Vt (0, T ) 
$1.53
$1.5012

 $0.0295
20 / 365
(1.045)
(1.055) 20 / 365
Because you are long, this is a gain of $0.0295 per British pound.
d. The answer is provided in Exhibit 8.8 of the textbook.
Ch. 12. Management of Economic Exposure
3. Suppose you are a British venture capitalist holding a major stake in an e-commerce startup in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S.
equity position. Assume that if the American economy booms in the future, your equity stake
will be worth $1,000,000, and the exchange rate will be $1.40/£. If the American economy
experiences a recession, on the other hand, your American equity stake will be worth $500,000,
and the exchange rate will be $1.60/£. You assess that the American economy will experience
a boom with a 70 percent probability and a recession with a 30 percent probability.
(a) Estimate your exposure to the exchange risk.
(b) Compute the variance of the pound value of your American equity position that is
attributable to the exchange rate uncertainty.
(c) How would you hedge this exposure? If you hedge, what is the variance of the pound value
of the hedged position?
Solution:
Prob = 0.70
P* = $1,000,000
Prob = 0.30
P* = $500,000
S = $1.40
S = $1.60
P = £714,300
P = £312,500
E(S) = (0.70)/(1.40) + (0.30)/(1.60) = £0.688/$
E(P) = (0.70)*(714,300) + (0.30)*(312,500) = £593,760/$
Var(S) = 0.00167
Cov(P,S) = 7,535
(a) b = Cov(P,S)/Var(S) = 7,535/0.00167 = 4,511,976 ($)
(b) b2Var(S) = (4,511,976)2*(0.00167) = 33,997,738,800
(c) Var(e) = Var(P) - b2Var(S) = 33,903,080,400 - 33,997,738,800 ≈ 0
You can hedge this exposure by selling $4,511,976 forward.
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International Financial Management 2017-2018
Tutorial 6 Solutions
Ch. 13. Management of Translation Exposure
1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure
report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.6 in the
text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.
Solution: The following table provides a translation exposure report for Centralia Corporation
and its affiliates under FASB 8, which is essentially the temporal method of translation. The
difference between the new report and Exhibit 10.6 is that nonmonetary accounts such as
inventory and fixed assets are translated at the historical exchange rate if they are carried at
historical costs. Thus, these accounts will not change values when exchange rates change and
they do not create translation exposure.
Examination of the table indicates that under FASB 8 there is negative net exposure for
the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies
is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc.
Consequently, if the euro depreciates against the dollar from €1.1000/$1.00 to €1.1786/$1.00,
as the text example assumed, exposed assets will now fall in value by a smaller amount than
exposed liabilities, instead of vice versa. The associated reporting currency imbalance will be
$239,415, calculated as follows:
Reporting Currency Imbalance=
- €3,949,0000
€1.1786 / $1.00
-
- €3,949,0000
€1.1000 / $1.00
= $239,415.
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International Financial Management 2017-2018
Tutorial 6 Solutions
5
International Financial Management 2017-2018
Tutorial 6 Solutions
Exhibit 10.6 (page 431, second ed.)
Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and
Spanish Affiliates, December 31, 2013 (in 000 Currency Units) according to FASB 52
Canadian
Mexican
Dollar
Peso
Swiss
Euro
Franc
Assets
CD200
Ps 6,000
€ 825
Accounts receivable
0
9,000
1,045
0
Inventory
0
15,000
1,650
0
Net fixed assets
0
46,000
4,400
0
CD200
Ps75,000
€ 7,920
SF
0
CD 0
Ps 7,000
€ 1,364
SF
0
Notes payable
0
17,000
935
1,400
Long-term debt
0
27,000
3,520
0
CD 0
Ps51,000
€ 5,819
SF1,400
CD200
(Ps25,000)
(€2,101)
(SF1,400)
Cash
Exposed assets
SF
0
Liabilities
Accounts payable
Exposed liabilities
Net exposure
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International Financial Management 2017-2018
Tutorial 6 Solutions
Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and
Spanish Affiliates, December 31, 2013 (in 000 Currency Units)
Canadian
Mexican
Dollar
Peso
Swiss
Euro
Franc
Assets
CD200
Ps 6,000
€ 825
Accounts receivable
0
9,000
1,045
0
Inventory
0
0
0
0
Net fixed assets
0
0
0
0
CD200
Ps15,000
€ 1,870
SF
0
CD 0
Ps 7,000
€ 1,364
SF
0
Notes payable
0
17,000
935
1,400
Long-term debt
0
27,000
3,520
0
CD 0
Ps51,000
€ 5,819
SF1,400
CD200
(Ps36,000)
(€3,949)
(SF1,400)
Cash
Exposed assets
SF
0
Liabilities
Accounts payable
Exposed liabilities
Net exposure
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