foreign exchange risk occur when there is of appreciation of the base currency to the denominated currency or deprecation
Question 1
Notably, foreign exchange risk occur when there is of appreciation of the base currency to the denominated currency or deprecation. For the case of Healthtech Co. And Yanta Co. despite the factor that Swiss francs and euros are highly correlated Yanta Co. has a high exposure risk based on the cash flow. This is because the company is exposed rate risk for both the cash inflow and cash outflow which are denominated by different currencies. This risk is termed as transaction risk where the cash flows are subject to unexpected changes in exchange rates through foreign currency denomination. Yanta Co. faces a risk of fluctuation of currency for both the cash inflow and cash outflow and lacks an accrued option to change the currency direction. It is worth noting that the two currency can appreciate or depreciate independent. Yanta Co. is also faced by an economic risk within the foreign exchange risk realm as it is faced with a higher problem of predicting the market value influenced by the unexpected exchange rate fluctuations of the euro and francs in cash inflow and outflow. Healthtech Co. has a limited foreign exchange risk as it has an option of choosing the currency of exchange in the cash inflow.
Question 2
- In this case the company we are going to discuss is Apple Inc. Notably, based on 2018 annual report, the company is faced with a transaction risk due to fundamental exposure to movements in foreign currency exchange rates in relation to non-United States dollar dominated operating and sales expenses worldwide. The appreciation and depreciation of the United States dollar in relation to the foreign currencies adversely affects the company foreign currency-denominated earnings and sales. For instance, when foreign currencies are weakened of foreign currencies relative to United States dollar will affect the company foreign currency denominated earnings such that it will be required to raise international pricing, which will in turn reducing demand for the products of the company. The company can also decide not to raise the local prices to fully offset the dollar strengthening which will in turn adversely affect currency-dominated earnings and sales. Conversely, when foreign currencies is strengthened relative to the US dollar will cause international pricing and incur losses on the derivative instruments of its foreign currency and as a result limit the benefits. Correspondently, the increase might also impact the cost of products denominated with the rising currencies which in turn adversely affecting gross margins. Notably, it is worth noting that Apple Inc. uses derivatives instruments such as option contracts and foreign currency forwards in order to hedge some exposure of foreign currency exchange rates fluctuations. In most cases, the company can only hedge a limited portion of the risks over a given period of time.
- In this case the home country of Apple. Inc. is United States and the foreign country that we will consider is China.
The annual inflation rate of United States = 1.9%
The annual inflation rate of China = 2.1%
China spot exchange rate = 0.53%
US spot exchange rate = 1.123%
e= 1.123-0.53 = 0.593
q = (1+ π)/[(1+e)(1+p*)]
q= ( 1+0.019)/[(1+0.593)(1-0.021) = 0.6265
The company home currency appreciated in 2018 and this impacted the company foreign currency denominated earnings such that it will be required to raise international pricing, which will in turn reducing demand for the products of the company.
Question 3
Possible $/NZD rate in 180 days Probability
$0.60 5%
$0.65 10%
$0.68 30%
$0.70 30%
$0.73 20%
$0.75 5%
The cost payable without heading are as shown below
| Scenario | Possible spot rate of NZS | Dollar payment with no hedging A | Probability B | Expected value A*B |
| 1 | 0.60 | 60,000 | 5 | 3,000 |
| 2 | 0.65 | 65,000 | 10 | 6,500 |
| 3 | 0.68 | 68,000 | 30 | 20,400 |
| 4 | 0.70 | 70,000 | 30 | 21,000 |
| 5 | 0.73 | 73,000 | 20 | 14,600 |
| 6 | 0.75 | 75,000 | 5 | 3,750 |
| Total expected value payables without hedging | 69,250 | |||
Cost payables = payables (NZ$) × Forward rate of $/NZ$
= NZ $100,000 × $0.72/NZD = $72,000
Real cost of hedging (RCHp) = hedging payable cost – payable when not hedged = $72,000 – 69,250 = $2,750
In this case it is evident that hedging is likely to be more costly to the company when the payment in dollar without hedging is not more than $72,000 which is possible for the first four cases in the table. As a result, there is a probability of 80% that payable cost with hedging will have a higher cost than hedging in the case of forward contract.
