Answer: Amount To Be Paid If Exposure Is Hedged In The Forwa

Answer 1amount To Be Paid If Exposure Hedged In The Forward Market E

In evaluating the appropriate amount to be paid when exposure is hedged in the forward market, the key principle is to determine the equivalent USD payment based on the expected DKK amount and the forward exchange rate. Given that the company is exposed to a payment of DKK 4,500,000 and the forward rate is 5.92, the calculation proceeds as follows:

The amount to be paid in USD if exposure is hedged through the forward contract can be calculated by dividing the DKK amount by the forward exchange rate :

Amount to be paid = DKK 4,500,000 / 5.92 ≈ $760,135

Thus, after three months, the company will pay approximately $760,135 to settle the DKK 4,500,000 obligation when hedged in the forward market.

Paper For Above instruction

Currency exposure risk is a critical concern for multinational corporations engaged in international trade. Hedging strategies, such as forward contracts and options, help firms manage these risks by locking in future exchange rates or providing flexibility to capitalize on favorable movements. This paper discusses the mechanisms and implications of hedging currency exposure, focusing on the forward market, present and future value calculations, and options strategies.

Hedging with Forward Contracts

Forward contracts are agreements to buy or sell a specific amount of currency at a predetermined rate on a future date. They are straightforward hedging tools that guarantee the exchange rate, thus providing certainty over foreign currency payments. The calculation of the hedged amount involves dividing the foreign currency obligation by the forward rate: DKK 4,500,000 / 5.92 ≈ $760,135. This amount ensures that the company commits to an exact USD payment, eliminating the risk of adverse currency movements. The certainty provided by forward contracts is crucial for companies with fixed future payment obligations, allowing for precise budgeting and financial planning (Eiteman, Stonehill, & Moffett, 2019).

Certainty of Hedged Payments

Taking a forward contract results in a 'certain' outcome, as the company effectively locks in the USD amount payable, regardless of future spot rate fluctuations. This certainty is crucial, especially when managing large international transactions where unforeseen currency movements could significantly impact costs (Shapiro, 2020).

Calculating the present value of future foreign currency amounts is also vital when assessing hedge effectiveness. For a future DKK payment of 4,500,000, discounted at an exchange rate or interest factor (for example, 1.0085), the present value is: DKK 4,462,072. Converting this to USD at the current spot rate (5.66) results in approximately $78,8352, indicating the current equivalent of the future obligation (Moffett, Stonehill, & Eiteman, 2018).

Future Value of Currency Hedging

The outcome of hedging strategies extends into the future, where the company's USD payment may increase due to interest or exchange rate shifts. For instance, after three months, with a slight appreciation of the USD by 1.5%, the USD amount payable becomes approximately $800,177, reflecting the combined effect of the initial hedge and currency movements. Such forecasts enable firms to anticipate future cost implications and make informed financial decisions (Dorfman, 2019).

Use of Options in Currency Hedging

Options provide an alternative hedging instrument that grants the right, but not the obligation, to buy or sell currencies at a specified strike price. If a company employs options, exercising the option at maturity involves paying a predetermined amount—here, approximately $769,230 for DKK 4,500,000 at a strike rate of 5.85. This flexibility is advantageous when favorable exchange rate movements occur, allowing the company to benefit from advantageous rates (Brealey, Myers, & Allen, 2017).

The total outcome when employing options includes the cost of the option premium (e.g., DKK 4,500,000 * 1.25%) and interest costs on the premium. The total payoff incorporates these costs and reflects possible scenarios of spot rates at maturity, including better or worse than strike rates (Hull, 2018).

Cost Analysis of Options

The initial cost of the option at inception equals DKK 4,500,000 multiplied by the premium rate, for example, DKK 4,500,000 * 1.25% ≈ $56,250. As interest accrues over the period at, say, 3.4% annually, the end-of-period cost adjusts to approximately $56,728, accounting for interest on the premium. Such detailed calculations allow firms to evaluate the economic viability of using options versus forward contracts (Kolb & Overdahl, 2018).

FX Scenario Analysis at Maturity

Evaluating different spot rate scenarios at maturity illustrates the effectiveness of option hedging. If at maturity, the spot rate improves to DKK 5.98, the company benefits by paying DKK 4,500,000 at the better spot rate, with total costs including premium and interest totaling roughly $809,236. Conversely, if the spot rate worsens to DKK 5.50, the company exercises the option and pays DKK 4,500,000 at the strike price, resulting in a total cost of approximately $825,958. These scenarios underscore the risk mitigation and cost implications of options (Madura & Fox, 2019).

Overall, currency hedging strategies significantly impact a company's financial position by managing risks associated with fluctuating foreign exchange rates. Forward contracts offer certainty but lack flexibility, while options provide adaptability at a premium cost. An informed choice depends on the company's risk appetite, cost considerations, and forecasted currency movements.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance. McGraw-Hill Education.
  • Dorfman, M. S. (2019). Introduction to Risk Management and Insurance. Prentice Hall.
  • Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson Education.
  • Kolb, R. W., & Overdahl, J. A. (2018). Financial Derivatives: Pricing and Risk Management. Wiley.
  • Madura, J., & Fox, R. (2019). International Financial Management. Cengage Learning.
  • Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2018). Fundamentals of Multinational Finance. Pearson.
  • Shapiro, A. C. (2020). Multinational Financial Management. Wiley.
  • Skugan, J. et al. (2017). Managing Currency Risk: Strategies and Tools. Journal of International Business Studies, 48(5), 623-640.
  • Gangemi, B. (2019). Currency Hedging and Corporate Financial Strategy. Financial Management, 48(2), 25-50.
  • Serra, B. (2020). The Use of Derivatives in Multinational Firms. Journal of Financial Economics, 136(2), 491-509.

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