1. Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S.

companies. Suppose it
has accounts receivable of $1.5 billion and accounts payable of $740 million. It also borrowed $600 million. The current spot rate is
$1.5128/£.

2 Walt Disney expects to receive a Mex$16 million theatrical fee from Mexico in 90 days. The current spot rate is $0.1321/Mex$
and the 90-day forward rate is $0.1242/Mex$.

3 A foreign exchange trader assesses the euro exchange rate three months hence as follows:

$1.11 with probability 0.25

$1.13 with probability 0.50
$1.15 with probability 0.25

The 90-day forward rate is $1.12.

4 An investment manager hedges a portfolio of Bunds (German government bonds) with a 6-month forward contract. The current spot
rate is €0.84:$1 and the 180-day forward rate is €0.81:$1. At the end of the 6-month period, the Bunds have risen in value by 3.75
percent (in euro terms), and the spot rate is now €0.76:$1.

a. If the Bunds earn interest at the annual rate of 5 percent, paid semi-annually, what is the investment manager's total dollar
return on the hedged Bunds?

b. What would the return on the Bunds have been without hedging?

5. Cooper Inc., a U.S. firm, has just invested £500,000 in a note that will come due in 90 days and is yielding 9.5% annualized. The
current spot value of the pound is $1.5612 and the 90-day forward rate is $1.5467.

a. What is the hedged dollar value of this note at maturity?

ANSWER. At maturity, this note will pay off £511,875 (500,000 x 1 + 0.095/4). The hedged dollar value of this note at maturity is
$791,717 (511,875 x 1.5467).

b. What is the annualized dollar yield on the hedged note?

ANSWER. The dollar investment in the note today is $780,600 (500,000 x 1.5612). The 90-day return is 1.424% (791,717/780,600 - 1).
Annualized, this dollar return is 5.697% (1.424% x 4).

c. Cooper anticipates that the value of the pound in 90 days will be $1.5550. Should it hedge? Why or why not?
ANSWER. If Cooper does not hedge, it will expect to collect at maturity $795,966 (511,875 x 1.5550). This amount exceeds the hedged
return. Whether it should hedge depends on how strongly it believes that its expectation of the 90-day spot rate is correct and the
forward market is wrong, and on its risk preferences. It also depends on whether it has an offsetting exposure, as the question in part c
indicates.

d. Suppose that Cooper has a payable of £980,000 coming due in 180 days. Should this affect its decision of whether to hedge its
sterling note? How and why?
ANSWER. Yes. If Cooper hedges its investment, it will actually exacerbate its pound exposure. As it stands, the pound investment
currently provides an offset of £511,875 to its negative exposure of £980,000, yielding a net exposure of -£468,125 (£511,875 -
£980,000). If Cooper hedges the pound investment, its net exposure rises to -£980,000.

6. American Airlines is trying to decide how to go about hedging SFr70 million in ticket sales receivable in 180 days. Suppose it
faces the following exchange and interest rates.

Spot rate: $0.6433-42/SFr

Forward rate (180 days): $0.6578-99/SFr
SFr 180-day interest rate (annualized): 4.01%-3.97%
U.S. dollar 180-day interest rate (annualized): 8.01%-7.98%
a. What is the hedged value of American's ticket sales using a forward market hedge?
ANSWER. By selling the ticket receipts forward, American Airlines can lock in a dollar value of 70,000,000 x 0.6578
= $46,046,000.

b. What is the hedged value of American's ticket sales using a money market hedge? Assume the first interest rate
is the rate at which money can be borrowed and the second one the rate at which it can be lent.
ANSWER. American can also hedge it euro receivable by borrowing the present value of SFr70 million at a 180-day
interest rate of 2.005% (4.01%/2), sell the proceeds in the spot market at a rate of $0.6433/SFr, and invest the dollar
proceeds at a 180-day interest rate of 3.99% (7.98%/2). Using this money market hedge, American can lock in a
value for its SFr70 million receivable of $45,907,296 (70,000,000/1.02005 x 0.6433 x 1.0399).

c. Which hedge is less expensive?

ANSWER. The forward market hedge yields a higher dollar value for the ticket receivables, so it is preferable.

7 Madison Inc. imports olive oil from Chilean firms and the invoices are always denominated in pesos (Ch$). It
currently has a payable in the amount of Ch$250 million that it would like to hedge. Unfortunately, there are no
drachma futures contracts available and Madison is having difficulty arranging a drachma forward contract. Its
treasurer, who recently received her MBA, suggests using Brazilian real (R) to cross-hedge the peso exposure.
She recently ran the following regression of the change in the exchange rate for the drachma against the change
in the real exchange rate:

ΔCh$/$ = 1.6(ΔR/$)
a. There is an active market in the forward real. To cross-hedge Madison's peso exposure, should the treasurer buy
or sell the real forward?

ANSWER. Given that Madison is short pesos and there is a positive correlation between the real and the peso, Madison
should create a long position in the real; that is, Madison should buy the real forward.

b. What is the risk-minimizing amount of reais that the treasurer would have to buy or sell forward to hedge
Madison's peso exposure?

ANSWER. According to the regression, a 1¢ change in the value of the real leads to a 1.6¢ change in the value of the
peso. To cross-hedge the forthcoming payment of Ch$, R1.6 must be bought forward for every peso owed. With a
peso exposure of Ch$250 million, the exporter must buy forward reais in the amount of R400 million (1.6 x
250,000,000).