Assignment- Currency risk

You may do this assignment alone or withoneother person. For each of your answers, be as specific as possible about all transactions and amounts involved.

All interest rates are stated as annual rates.

Part 1 Transaction risk

1.

a. Select a foreign currency
b. Find the spot exchange rate for that currency
c. Select an amount between 150 million and 200 million
d. Select a number of months between 3 and 9
e. Select either payable or receivable. If you select payable, for the rest of the questions in this part of the assignment, assume a US firm is required to make a payment of the number selected in part cof the foreign currency from part a at the time selected in part d. If you select receivable, assume a US firm expects to receive a payment of the number of units selected in part c of the foreign currency from part a at the time selected in part d.
f. Describe the future payment (in $) from the above assumptions if the exchange rate remains the same as it is today.

2. Explain how the firm can use leading or lagging to reduce the exchange rate risk created by this payment.

3. Assume the US interest rate is 2% and the foreign interest rate is 5%, how can the firm hedge the transaction risk associated with the payment using a money market hedge?

4

a. How can the firm hedgethe transaction risk associated with the payment using a forward market hedge?

b. If the forward price is 1% lower than the spot exchange rate (from 1b) and the actual exchange rate on the date the payment is due is 1% higher than the spot exchange rate, what will the dollar value of the amount the firm pays or receives on the due date be?

c. If the forward price is 2% higher than the spot exchange rate (from 1b) and the actual exchange rate on the date the payment is due is 1% higher than the spot exchange rate, what will the dollar value of the amount the firm pays or receives on the due date be?

5.

a. How can the firm hedge the risk associated with the payment using a foreign currency option?

b. If the option's strike price is equal to the spot exchange rate (from 1b) and the actual exchange rate on the payment is due is 2% lower than the spot market price, will the firm exercise the options and what will the dollar amount the firm pays or receives on the due date be?

c. If the option's strike price is equal to the spot exchange rate (from 1b) and the actual exchange rate on the payment is due is 2% higher than the spot market price, will the firm exercise the options and what will the dollar amount the firm pays or receives on the due date be?

6. How could the firm hedge the transaction risk associated with this payment by exposure netting or funds adjustment?

Part 2 Economic risk

1. Obtain weekly stock prices for the last five years for a US company and a foreign company of your choice.

2. Obtain exchange rates for three different foreign currencies, one of which must be the British pound or the Euro, and the other the Japanese yen, the Mexican peso, the Canadian dollar, and the third the currency of the country where the foreign firm is located for the same dates as the stock prices in question 1. (If the foreign firm is located in the UK or the euro area, use the other of the two as your first currency. If it is located in Japan, Mexico or Canada, use one of the other two currencies as your second currency.)

3. Calculate weekly returns on each stock and weekly percentage changes in the exchange rate for each currency.

4. Determine the economic risk of the US stock and the foreign stock with respect to each of the foreign currencies. (You will have a separate regression for company and currency; a total of six regressions.)

For each company and currency:

(a) Describe the magnitude of the stock's risk relative to the currency (e.g., "a 1% increase in the value of the currency is associated with a ___% change in the value of the stock").

(b) Indicate whether the stock price increases or decreases as the value of the foreign currency increases.

(c) Determine whether the company's risk relative to that currency is statistically significant.

(d) Indicate what portion of the stock return volatility canbe eliminated if the currency risk were hedged perfectly.