1. How the hedge will accomplish the goal of CFC of protecting the value of its foreign currency cash flows?
Spot exchange rates are risky for MNEs as the primary determinant of host country demand depends largely on the price of its goods, services, labor and entrepreneurship (GSLE). Particularly true to unstable currencies, price competitiveness of an exporting MNE is pegged on fluctuations of host country’s currency. If spot rate suggests that the host (say, Japan) currency depreciates, home MNE (say, based in US) GLSE becomes expensive since importers face a stronger dollar. When sold to end-users, adverse reactions such as added-costs without added-value or simply look at the exporter’s products as unfair may result. If the spot rate change is cyclical, the MNE is on a relatively comfortable zone. However, when fluctuations are regular and the direction is unpredictable, the submission of MNE to trade depends on how much risk it can hold. When MNE investors become anxious in achieving expected foreign cash flows, this is when hedging becomes useful.
Since forward foreign currency contracts assume that parties tend to maximize their utility, it can also predict the expected spot rate of foreign currency. This can be helpful for risk-averse MNEs especially when they are only engaging to get a break-even point or fair gains from trade. It can simply quote its desired level of foreign currency valuation with respect to its GLSE. Thus, international trade tends to be stable in both demand and supply since speculation is minimized in favor of arriving at forward rates. In the financial market, forward rates can also result for investors to continuously invest over a period of with little slack time. As a result, in-need MNEs can gain access to capital easily and readily. This will also imply that investors are less speculating rather they become more firm-specific. In effect, quality of products and efficiency can also be outcomes of forward quotations.
2. What are the expected cash flows from the DM transaction if it is hedged in the foreign market?
CFC transaction of DM 2,000,000 falls in 90-day forward which results in US,146,600.
3. How would CFC hedge DM in the money market? And how much will it receive in the money market hedge?
In the money market hedge, the DM 2,000,000 will be subjected to two different interest rates from the currency loan; namely, US0,940.80 if acquired in prime rate while US9,193.60 if acquired in LIBOR (London). In the former, the total money would be US,023,859.20 while the latter is US,025,606.40 with a difference of US,747.20 in favor of the LIBOR.
4. Which is the best alternative for German transaction?
Interest rate differential has adverse impacts to multinational enterprises (MNEs) particularly on the aspect of seeking for capital in the financial market. Disincentive will accrue to them if additional costs of monitoring will result from finding an efficient financial market especially when it is publicly traded in different countries. When the interest rate of the home country is higher than the host country, home investors would shift to host country. This will make financial markets more ambiguous for investors, thus, more complicated for their investment decisions. In effect, the slack time used to speculate and identify arbitrage opportunities result to lesser capital source for MNEs. This will in turn have adverse impacts on their production and distribution while innovation would not be possible. Thus, interest rate differential posts bottleneck for the global economy.
The conditions of the German transaction are as follows: hotel client is opening, parts of order are already shipped, last consignment will be delivered on the second week of October 1991 and November 14 is the payment date. This should be hedged in the money market because it is compatible to take advantage of the LIBOR’s lower interest rate. Therefore, the risk to CFC of not getting the gain in investment in money market is mitigated.
5. What is the expected cash flow in JY transaction in forward market?
The transaction in Japan falls in the 30-day forward which amounts to US,120,500,000.
6. How inflows in JY be hedged in the money market? What are the expected cash flows?
If quoted in prime rate, the expected cash flow would be US,049,349,600 while in LIBOR it will be US,051,703,910 with a difference of US,354,310. Due to substantial amount of the transaction, it can be hedged in the money market through cross-country investment.
7. What should be done in JY inflows?
Using the foreign exchange (FE) theory, however, concerned countries and firms can anticipate the level of differential through expectations on inflation rate. Monetary authorities can simply influence local interest rates depending on the rate of inflation, thus, canceling or mitigating future interest rate differentials. On the other hand, when differential is already established, forward exchange rates can limit speculations from investors as suggested by IRP theory. Expected change on spot exchange rate can also be used for forward transactions as long as it is based on interest rate differential (IFE theory). By these tools, arbitrage opportunity can be closed. Therefore, it is advisable to use the forward currency alternative.
The following conditions exist in Japan transaction; namely, the client is large located in the country’s capital, payment will be given in September 1991 and the orders was already shipped in August 1991. The client has large bargaining power position. CFC cannot afford to loose this client that forward exchange is necessary. The large base amount would also infuse too much risk when loan is not paid. The stocks are issued and CFC has no other asset to pay the loan and its interest if the Japan client extends the payment period due to financial bottlenecks.
8. What is the cash flow on Singapore transaction in the money market?
The net cash flow is US1,866.03.
Appendices
Germany
Japan
Singapore1
Sing 2
Sale price (DM)
2,000,000.00
1.5E+11
250,000.00
250,000.00
Remarks
Hotel client, opening, parts of order alerady shipped, last consignment on second week of Oct 1991, payment will be given on Nov. 14
large trading company in Tokyo, payment will be given on Sep 18, 1991, shipped on Aug
due on nov 23, 1991 from furniture retailer, shipped in the last week of july
another from the same company on 2/17/92, shipment will be made on December 1991
Cash flow in the forward market
Contract Price
Spot
30-day forward
90-day forward
180-day forward
Germany
2,000,000.00
1,164,800.00
1,159,200.00
1,146,600.00
1,140,000.00
Japan
1.5E+11
1,121,100,000.00
1,120,500,000.00
1,118,100,000.00
1,115,250,000.00
Sing 1
250,000.00
143,700.00
Sing 2
250,000.00
143,700.00
TOTAL
1,121,934,000.00
PREVIOUS
In the money market
Contract Price
1-month
3-months
6-months
Germany
2,000,000.00
140,940.80
Japan
1.5E+11
7.2E+07
Sing 1
250,000.00
7,515.51
Sing 2
250,000.00
8,018.46
On LIBOR
Germany
139,193.60
Japan
6.9E+07
Sing 1
Sing 2
Total at prime rate
Total at LIBOR rate
Germany
1,023,859.20
1,025,606.40
Japan
1,049,349,600.00
1,051,703,910.00
Sing 1
136,184.49
Sing 2
135,681.54
1,050,645,325.23
1,052,729,516.40
Credit:ivythesis.typepad.com
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