International Financial Management

Questions

2. How large is Diva’s yen exposure forecast to be in September 1995?
3. How does the yen exposure differ from Italian lira exposure?

1. What factors affect the firm’s exposure to exchange rate risk?

Foreign Exchange Risk

“The risk that foreign currency profits may evaporate in domestic currency (NOK) terms due to unanticipated unfavourable exchange rate movement” Lecture 1, Johann Reindl

Diva Shoes is a US based company that operates and sell their products globally. Hence, it is reasonable to assume that the company is affected by exchange rate risk as they operate in a market that requires transactions between different currencies. In the following we will cover some risk factors that affects Diva Shoes. There are several factors that are important to take into consideration in a transaction, and the exchange rate plays a big part in this.

Variety in interest rates
The Japanese has a decreasing interest rate as we can see from exhibit 3. A decreasing interest rate does not have a major impact on the exchange rate, but over time, a higher interest rate attracts foreign capital and therefore the exchange rate will also naturally rise. Decreasing interest rates is rather correlated to inflation and this can, in addition to other factors, cause a decreasing currency.

Variety in inflation
Over the course of 1990-1994, the Japanese inflation has decreased. As mentioned above this strengthens the YEN against USD. Clearly, these macro-economic factors will also have an impact on Diva Shoes as revenues from the Japanese market will decrease.

Transactional (contractual) exposure

This can be referred to as the risk that the company´s equities, assets, liabilities or income will be affected by changes in the exchange rate. It is assumed that this applies for Diva as orders are typically placed half a year in advance of final shipment, and only parts of the total amount are paid when the order is placed.

Other factors
It is worth mentioning that there are other factors that can affect Diva Shoes, such as Trade balance, translation exposure, commodity prices and other macro-economic factors.

1. How large is Diva’s yen exposure forecast to be in September 1995?

In the Japanese market, we see from exhibit 4 that expected revenues in September 1995 are YEN 1,803,519,043. This amount also consists of wholesalers. As mentioned, wholesales orders are orders typically placed half a year in advance of final shipment, and only parts of the total amount are paid when the order is placed. This is reported in page 2, first paragraph of the case. Hence, our previous assumption that Diva Shoes are exposed to exchange rate risk is supported by this. Revenues in the interval 01.04.1995-28.09.1995 are therefore exposed to foreign exchange risk.

1. Comparison between Yen/Lira exposure

Commodities purchased from Italian suppliers, and sales revenues leaves Diva Shoes exposed to the lira. The number of conversions from Lira to USD is limited, this is due to the commodities, and the fact that the company gets paid from sales in Lira. Also, this works as an operational hedge. Business with Japan results in a one-way cash flow which also leads to higher risk for Diva Shoes.

Suppose that Diva chooses on April 1 to hedge its September 1995 exposure in yen using a forward contract or a currency option with a strike price equal to the prevailing forward rate.

Derive the hedging strategy that Diva would implement with either financial instrument. Draw the payoffs and profits of the position at maturity for each alternative with the exchange rate defined in USD/JPY 10,000 un its (see footnote 1 in appendix B for the reason). What do you see as the trade-offs between alternatives?

Alternative hedging strategies

Forward-contract:

[pic 1]

=89.6*[(1+0.0169*0.5)/(1+0.0612*0.5)]

=87.67 JPY/USD

=0.0114 USD/JPY

or in units of 10,000:

=114.059 USD/JPY 

Annual 6-month yield on Japanese and U.S government bond (exhibit 3) and the JPY/USD spot-rate for 1/4/1995 (exhibit 4) has been used for this computation.

The payoff of this hedging strategy would be:

(1,643,233,000*114.059)/10,000= $18,742,551

PAYOFF-TABLE

By using this strategy, Diva Shoes will hedge themselves against FX-volatility by entering a short position in this forward-contract, i.e Diva Shoes will sell the predicted amount of foreign currency that they receive as sales-revenue in the future, at a price that is fixed today.

Option:

S0 = (1/89.6)*10,000= 111,607 USD/JPY (spot exchange-rate 1/4/1993 for 10,000 units)

X=114,059 USD/JPY (strike-price in 10,000 units)