Hedgehog International owes 500,000 local currency units to its foreign supplier in 90 days. The current spot rate of the local currency unit is $.60. Hedgehog purchases a call option to buy the local currency unit in 90 days for $.61 for a premium of $.005. The exchange rate for the local currency increases to $.63 in 90 days. What will Hedgehog do on the payables' settlement date?
Answer(s): A
Choice "a" is correct. Hedgehog will exercise its option and liquidate the payables associated with the proceeds. The exercise of the option represents a less costly alternative than acquisition of proceeds at the spot rate at the time the payables are due. The net impact of exercise of the option is computed as follows:The premium is a sunk cost and is irrelevant to the decision. Note that the premium is a factor in determining the net gain (loss) but not in deciding whether to exercise the option. Choices "b", "c", and "d" are incorrect, per computation above.
Hedgehog International has a receivable valued at 500,000 local currency units from its foreign customer due in 90 days. The current spot rate of the local currency unit is $.60. Hedgehog purchases a put option to sell the local currency unit in 90 days for $.61 for a premium of $.005. The exchange rate for the local currency increases to $.63 in 90 days. What will Hedgehog do on the receivable's settlement date?
Answer(s): B
Choice "b" is correct. Hedgehog will not exercise its option and will, instead convert the local currency units collected from the receivables to its domestic currency by selling that currency at the spot rate at the time of collection. The exercise of the option represents a less profitable alternative than sale of the accounts receivable proceeds at the spot rate at the time the receivables are collected. The exercise of the option in comparison to allowing the option to expire is computed as follows:The premium is a sunk cost and is irrelevant to the Explanation. Note that the premium is a factor in determining the net gain (loss) but not in deciding whether to exercise option. Choices "a", "c", and "d" are incorrect, per computation above.
Hedgehog International has numerous foreign exchange transactions. Management has elected to hedge transactions as a means of mitigating transaction exposure to exchange rate risk. What is the most effective means that Hedgehog International can use to avoid overhedging?
Answer(s): C
Choice "c" is correct. Hedgehog should only acquire the minimum amount of hedge contracts needed to offset the effect of known transactions.Choice "a" is incorrect. Parallel loans represent a swap contract for hedging long-term transaction exposure and are not specifically designed to mitigate the risk of overhedging. Choice "b" is incorrect. Acquisition of the maximum number of hedge contracts for known and projected transactions exposes the organization to greater risk of overhedging since projected transactions might not materialize.Choice "d" is incorrect. Cross hedging involves techniques related to currencies that do have hedge instruments available to mitigate risk and are not specifically designed to avoid overhedging.
An American importer expects to pay a British supplier 500,000 British pounds in three months. Which of the following hedges is best for the importer to fix the price in dollars?
Choice "a" is correct. To fix a price in dollars to buy British pounds, British pound call options should be purchased. Call options would allow, but not require, the purchaser of the call to acquire the currency (British pounds) for a specified price at or before a specified time in the future. If the price goes down, the purchaser (the importer) would exercise the options; if not, the purchaser (importer) would buy the British pounds in the market and let the options expire. British pound futures could also be used, but that was not one of the choices listed. Choice "b" is incorrect. Buying British pound put options would allow, but not require, the purchaser of the put to sell the currency for a specified price at a specified time in the future. Since the importer needs British pounds, buying put options would not work. The importer needs to end up with British pounds.Choice "c" is incorrect. Selling British pound put options would not work. The importer needs to end up with British pounds. Selling put options could work, but the option would be exercised, or not, by the purchaser and not by the importer. If the options were not exercised, the importer could end up with nothing (other than the option premium).Choice "d" is incorrect. Selling British pound call options would not work. The importer needs to end up with British pounds; if call options are sold, the other party can exercise the options or let them expire, and if the options were exercised, the importer would have to supply the British pounds. This answer is backwards.
What is the effect when a foreign competitor's currency becomes weaker compared to the U.S.dollar?
Choice "a" is correct. As a foreign competitor's currency becomes weaker compared to the U.S. dollar, the product becomes less expensive in U.S. dollars. The less expensive product will have the advantage in the U.S. market.Choice "b" is incorrect. As a foreign competitor's currency becomes weaker compared to the U.S. dollar, the product becomes less expensive in U.S. dollars. The less expensive product will have the advantage in the U.S. market, not a disadvantage.Choice "c" is incorrect. Foreign currency exchange rates impact both sales and possibly cost of goods sold of a competing domestic company. Sales within U.S. markets will deteriorate as the currency of foreign competitors deteriorates and makes the domestic company's goods more expensive. As a foreign competitor's currency appreciates, sales within U.S. markets by a domestic company should also increase as goods manufactured in the U.S. become less expensive. Cost of goods sold may fluctuate if foreign suppliers are used.Choice "d" is incorrect. It is better for a U.S. company when the value of the U.S. dollar weakens, not strengthens. A weak U.S. dollar makes domestic goods relatively less expensive that imported goods.Supplemental Questions
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