What is the hedged cost of DKNY’s payable using a put option?
Based on these quotes, the treasurer presents you with a series of questions that she would like you to address.
Questions
1. What hedging options are available to DKNY?
2. What is the hedged cost of DKNY’s payable using a forward market hedge?
3. What is the hedged cost of DKNY’s payable using a money market hedge?
4. What is the hedged cost of DKNY’s payable using a put option?
5. At what exchange rate is the cost of the put option just equal to the cost of the forward market hedge? To the cost of the money market hedge?
6. How can DKNY construct a currency collar? What is the net premium paid for the currency collar? Using this currency collar, what is the net dollar cost of the payable if the spot rate in 30 days is Mex$12.8/$? Mex$13.1/$? Mex$13.4/$?
7. What is the preferred alternative?
8. Suppose that DKNY expects the 30-day spot rate to be Mex$13.4/$. Should it hedge this payable? What other factors should go into DKNY’s hedging decision?
9 For elaboration, see Ian H. Giddy, “The Foreign Exchange Option as a Hedging Tool,” Midland Corporate Finance Journal, Fall 1983, pp. 32-42.
10.7 Summary and Conclusions
In this chapter, we examined the concept of exposure to exchange rate changes from the perspective of the accountant. The accountant’s concern is the appropriate way to translate foreign-currency-denominated items on financial statements to their home currency values. If currency values change, translation gains or losses may result. We surveyed the four principal translation methods available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current rate method. In addition, we analyzed the present translation method mandated by the Financial Accounting Standards Board, FASB-52.
Regardless of the translation method selected, measuring accounting exposure is conceptually the same. It involves determining which foreign-currency-denominated assets and liabilities will be translated at the current (postchange) exchange rate and which will be translated at the historical (prechange) exchange rate. The former items are considered to be exposed, whereas the latter items are regarded as not exposed. Translation exposure is simply the difference between exposed assets and exposed liabilities.
Hedging this exposure is a complicated and difficult task. As a first step, the firm must specify an operational set of goals for those involved in exchange risk management. Failure to do so can lead to possibly conflicting and costly actions on the part of employees. We saw that the hedging objective that is most consistent with the overarching objective of maximizing shareholder value is to reduce exchange risk, when exchange risk is defined as that element of cash-flow variability attributable to currency fluctuations. This objective translates into the following exposure management goal: to arrange a firm’s financial affairs in such a way that however the exchange rate may move in the future, the effects on dollar returns are minimized.
We saw that firms normally cope with anticipated currency changes by engaging in forward contracts, borrowing locally, and adjusting their pricing and credit policies. However, there is reason to question the value of much of this activity. In fact, in normal circumstances, hedging cannot provide protection against expected exchange rate changes.
A number of empirical studies indicate that on average the forward rate appears to be an unbiased estimate of the future spot rate. On the other hand, the evidence also points to the possibility of bias in the forward rate at any point in time. However, trying to take advantage of this apparent bias via selective hedging is likely to expose the company to increased risk.
Furthermore, according to the international Fisher effect, in the absence of government controls, interest rate differentials among countries should equal anticipated currency devaluations or revaluations. Empirical research substantiates the notion that over time, gains or losses on debt in hard currencies tend to be offset by low interest rates; in soft currencies, they will be offset by higher interest rates unless, of course, there are barriers that preclude equalization of real interest rates. Again, to the extent that bias exists in the interest rate differential—because of a risk premium or other factor—the risk associated with selective hedging is likely to offset any expected gains.
The other hedging methods, which involve factoring anticipated exchange rate changes into pricing and credit decisions, can be profitable only at the expense of others. Thus, to consistently gain by these trade-term adjustments, it is necessary to deal continuously with less-knowledgeable people. Certainly, however, a policy predicated on the continued existence of naive firms is unlikely to be viable for very long in the highly competitive and well-informed world of international business. The real value to a firm of factoring currency change expectations into its pricing and credit decisions is to prevent others from profiting at its expense.
The basic value of hedging, therefore, is to protect a company against unexpected exchange rate changes; however, by definition, these changes are unpredictable and, consequently, impossible to profit from. To the extent that a government does not permit interest or forward rates to fully adjust to market expectations, a firm with access to these financial instruments can expect, on average, to gain from currency changes. Nevertheless, the very nature of these imperfections severely restricts a company’s ability to engage in such profitable financial operations.