Essay about Chapter 8 Problems

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Chapter 8 1,4,5

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months. (a) What is the expected gain/loss from the forward hedging? The expected gain from this sale can be figured by using this equation: 10,000,000(1.10-1.05)=10,000,000(.05)=$500,000 expected gain (b) If you were the financial manager of Cray Research, would you recommend hedging his euro receivable? Why or why not? Cray Research should hedge in this situation. Hedging will …show more content…
Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability. (a) Estimate your exposure (b) to the exchange risk. (b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty. (c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging. (a) E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580 E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44 Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2 = .00096+.00144 = .0024. Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20 (b) = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500. This poses a negative exposure. As the pound gets stronger (weaker) against the dollar, the dollar value of the British holding goes down (up). (b) b2Var(S) = (-5500)2(.0024) =72,600($)2 (c) Buy £5,500
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