Assignment 3

Way to measure company transaction exposure

1) If company wait and exchange the Canadian dollars in October at prevailing

spot exchange rate at that time, the company may face with losses as the risk of
exchange rate fluctuated is very high as there are many factors that can affect
exchange rate fluctuation.

By looking at the information given, there is the probability that the U.S. currency
will be appreciated. According to the historical exchange rate graph between US$ and
Cdn$ we will see that, the trend is downward trend as the U.S.$ tend to be appreciated
if we forcast the exchange rate by market base forecasting. Also, the historical
forward rate of the U.S. and Canada is downward trend so it implied that the future
spot rate of the U.S tent to be appreciated.

However, if we employ the purchasing power parity of international fisher

effect parity we will reach the expectation that the U.S currency expected to
depreciated. As both inflation and interest rate in the U.S. is higher than Canada, so
people buy more foreign goods and finally US$ will depreciated.

In reality, there are many factors that can affect the exchange rate fluctuation
likes confounding effect or no substitute of traded goods so it is a worse decision to
allow the firms to exposed to the exchange rate risk without hedging.

2) Buy forward contracts for all of the payable, locking in the Canadian dollar
price. Currently, the prevailing spot rate is equal to 0.6298 US$/ Cdn$ and the
6 month forward rate at April 1, 2002, for contract buying up to US$100
million was 0.6271 US$/ Cdn$
Forward premium calculated as followed;

Pf = (0.6271 – 0.6298) / 0.6298 * 100 = -0.4287%

Forward discount in this case implied that US$ appreciated by -0.4287%, if we enter
forward buy it means that we will buy US$ at more expensive price from the current
spot rate by -0.4287%. Therefore, we can conclude that the company lock themselves
to buy 60,000,000 million US$ for the future payment with pay more from the current
spot rate about 0.4287%. In other words, we can hold that 0.4287% is the expense of
the company to exchange their income to make payment in foreign currency.

In next 6 month , company must pay = 60,000,000 us$ / 0.6271 = 95,678,520.17

Cdn$. To be profit from the tour packaging, they must generate income not less than
95,678,520.17 Cdn$.

3) Borrow Canadian Dollar to buy US. Dollars on April 1, 2002, and invest
the U.S. dollars for six months. The loan will be paid by using the Canadian dollars
available for the hotel payment. By doing this we can hedge the company against risk
of transaction exposure that may occurred when exchange rate expected to be
fluctuated. As we can match the cash inflow with cash outflow as it will offsetting
each other. However, the interest rate differential between two countries have the
impact on offsetting effect of cash flow of the firms.

Borrowing Rate Deposit Rate

Canada 2.7% 2.55%
U.S. 1.85% 1.65%

As we have to borrow Canadian dollars to buy US$ to make a payment in next 6

month at current spot rate which is 0.6298 US$/ Cdn$ and then we will use that funds
to invest in the U.S. so the method are followed
Amount need to borrow : By calculated present value of 60,000,000 US$ at the U.S.
deposit rate (6 month) which is (1.65% / 2 ) = 0.825%. The borrowing rate for 6
month will be 2.7% / 2 = 1.35%

Amount need to borrow = 60,000,000 US$ / ( 1 + 0.825% )

= 59,509,050.33 US$
Convert in to Cdn$ = 59,509,050.33 US$ / 0.6298 = 94,488,806.5 Cdn$
Borrow @ 1.35% = 94,488,806.5 Cdn$
Principle + Interest = 94,488,806.5 Cdn$ * ( 1 + 1.35% ) = 95,764,405.39 Cdn$

Today 6 month

Payment of Priciple + Int

Borrow 94,488,806.5 Cdn$
@ 1.35%
Pay = 95,764,405.39 Cdn$

Minimum receivable
that firm should get
= 95,764,405.39 Cdn$

Convert to US$ Invest in the U.S.

@ spot 0.6298 @ 0.825%
59,509,050.33 Get = 60,000,000 US$

Use 60,000,000 US$

to make the payment

By comparing the minimum receivable that the firm must be generated to

cover the cost of hedging by enter forward buy and borrow domestic and invest in
foreign we will see that, the minimum receivable from forward sell is equal to
95,678,520.17 Cdn$ while borrow from home and invest in foreign is equal to
95,764,405.39 Cdn$. The difference is equal to 85,885.22 Cdn$
Recommendation

Therefore, it obviously see that enter forward sell contract is better choice for
the firm as the minimum receivable that firm must generate to cover the cost of
hedging is lower. This will increase the firm ability to gain higher margin in operating
business and to be more effective to control the payable in the future. To be more
simplify, by using forward contract firm pay premium for hedging equal to the U.S.
forward discount which is -0.4287% as implied cost of hedging of 0.4287% to the
firm but for borrowing, the expense or cost of hedging that incurred is equal to the
different between borrowing rate in Canada and investing rate in the U.S. which is
equal to 0.525% (1.35% - 0.825%). By using forward contract, firm can lock
themselves at the predictable level of risk. It help the firm in pricing their package at
lowest possible price as the cost of hedging pass by the firm is minimized and at the
same time, they can control their payable position to be not volatile that much.

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