Example Foreign Exchange Problems Fall

Transaction 1 – Sheepskins PURCHASE FUZZY SHOES of USA purchases sheep skins from Australia. FUZZY SHOES will pay AUS$ 25,000,000 in 90 days. The present spot exchange rate is US$0.9526/AUS$. The 90 day forward contract exchange rate is US$ /AUS$. The annual prime lending rate in Australia is 2.50% per annum. The annual deposit rate in Australia is 2.10% per annum. FUZZY SHOESS cost of capital is 9.00% per annum. 2

What could happen? Value of purchase transaction today in US$ AUS$ 25,000,000 X US$ /AUS$ = US$ 23,815,000 Depreciation of US$ example AUS$ 25,000,000 X US$ /AUS$ = US$24,282,500 Appreciation of US$ example AUS$ 25,000,000 X US$ /AUS$ = US$ 23,622,500 Dont know what will happen – leads to actions to prevent foreign exchange rate risk 3

90 Day Forward Contract AUS$ 25,000,000 X US$ /AUS$ = US$ 23,672,500 paid in 90 days Need Present Value (PV) of this payment, must discount by FUZZY SHOESs cost of capital PV = Forward Value = US$ 23,672,500 = US$ 23,151,589 (1+ cost of capital ) ( ) fraction of year 4 4

Asset – Liability Hedging FUZZY SHOES has an Accounts Payable of AUS$ 25,000,000, a Liability, and needs to match with an Asset, a 90 day bank deposit in Australia. The logic is that after 90 days, the bank deposits principal and interest will pay off the Accounts Payable. The amount to deposit in Australia: Amount for deposit = Value of Accounts Payable (1 + deposit rate ) fraction of year = AUS$ 25,000,000 = AUS$ 24,869,435 ( ) 4 Amount of US$ required for the AUS$ 24,869,435 bank deposit: AUS$ 24,869,435 X US$ /AUS$ = US$ 23,690,623 5

Which to choose? PV of 90 day Forward Contract = US$ 23,151,589 Asset-Liability Hedging = US$ 23,690,623 Choose Forward Contract – Pay less US$ for the purchase Lessons –Must make financial calculations to make choice –Must determine present value of forward contract by discounting using firms cost of capital –No method of foreign exchange risk protection is always better than another, can only be determined through financial analysis 6

Transaction 2 – Shoe SALE FUZZY SHOES sells UK£ 10,500,000 of sheepskin shoes in the United Kingdom (UK) and will receive payment in 180 days. The spot exchange rate is US$ / UK£. The 180 day forward contract exchange rate is US$ / UK£. The annual prime lending rate in the UK is 4.22% per annum. The annual bank deposit rate in the UK is 1.00% per annum. FUZZY SHOESs cost of capital is 9.00% per annum. 7

What could happen? Value of transaction today in US$ UK£ 10,500,000 X US$ /UK£ = US$ 16,795,800 Depreciation of US$ UK£ 10,500,000 X US$ /UK£ = US$ 16,960,650 Appreciation of US$ UK£ 10,500,000 X US$ /UK£ = US$ 16,647,750 Dont know what will happen – leads to actions to prevent foreign exchange rate risk 8

180 Day Forward Contract UK£ 10,500,000 X US$ / UK£ = US$ 16,772,700 received in 180 days Need Present Value (PV) of this sale, must discount by FUZZY SHOESs cost of capital PV = Forward Value = US$ 16,772,700 = US$ 16,050,430 (1+ cost of capital ) ( ) fraction of year 2 9

Asset – Liability Hedging FUZZY SHOES has an Accounts Receivable of UK£ 10,500,000, an Asset, and needs to match with a Liability, a 180 day loan in the UK. The logic is that after 180 days, the received payment will be sufficient to pay off the 180 bank loan principal plus interest. The amount to borrow in UK: Amount to Borrow = Value of Accounts Receivable (1 + borrowing rate) fraction of year Amount to Borrow = UK£ 10,500,000 = UK£ 10,283,028 ( ) 2 Amount of US$ received from the UK£ 10,283,028 bank loan: Multiple todays spot rate US$ /UK£ X UK£ 10,283,028 = US$ 16,448,731 10

Which to choose? PV Forward Contract = US$ 16,050,430 Asset-Liability Hedging = US$ 16,448,731 Choose Asset-Liability Hedging – Receive more US$ for the sale Lessons –Must make financial calculations to make choice –Must determine present value of forward contract by discounting using firms cost of capital –No method of foreign exchange risk protection is always better than another, can only be determined through financial analysis 11