ABC Co. expects to receive 5 million euros in one year from exports. It can use any one of the following strategies to deal with the exchange rate risk.

Main Assignment:

Treasury and Risk Management

Question 1

On Friday, September 13, 1992, the Italian lira was worth DM 0.0013065. Over the weekend, the lira devalued against the DM to DM 0.0012613.

1. By how much had the lira devalued against the DM?
2. By how much had the DM appreciated against the lira?
3. Suppose Italy borrowed DM 4 billion, which it sold to unsuccessfully prop up the lira. What were the Bank of Italy’s lira losses on this currency intervention?
4. Suppose Germany spent DM 24 billion in an attempt to defend the lira. What were the Bundesbank’s DM losses on this currency intervention?

 

Question 2

 

Find a recent example of a nation’s foreign exchange market intervention and note what the government’s justification was. Does the justification make economic sense in your opinion? (Question 2’s answers in Point Form) (10 marks)

 

Question 3

 

ABC Co. expects to receive 5 million euros in one year from exports. It can use any one of the following strategies to deal with the exchange rate risk.

 

(i) Unhedged strategy

 

(ii) Forward hedge strategy

 

(iii) Money market hedge

 

(iv) Option hedge

 

The spot rate of the euro as of today is $1.10 and the 1 yr forward rate of EUR vs USD  = $1.15.

Interest rate parity exists. ABC uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8% versus an annual interest rate of 5% in the euro zone.

 

Put options on euros are available with an exercise price of $1.11, an expiration date of one year from today, and a premium of $0.06 per unit.

 

Call options on euros are available with an exercise price of $1.15, an expiration date of one year from today, and a premium of $0.08 per unit.

 

1. Identify the risks of each strategy and estimate the dollar cash flows it will receive as a result of using each strategy. (20 marks) (Focus more on this)
2. Which hedge is optimal and why do you think so? (5 marks)