1. A company sold a super computer to an Institute in Germany on credit and invoiced DM 10 million payable in six months. Presently, the six-month forward exchange rate is $1.50/DM and the foreign exchange advisor for Cray Research assumes that the spot rate is likely to be $1.43 in six months.
(1) What is the expected gain or loss from the forward hedging?
(2) If you were the financial manager of Cray Research, would you suggest hedging this DM receivable? Why or why not?
(3) Suppose the foreign exchange advisor assumes that the future spot rate will be similar as the forward exchange rate quoted today. Would you suggest hedging in this case? Why or why not?
Answer: (a) Expected gain($) = 10,000,000(1/1.50-1/1.43)
= 10,000,000(.6667-.6993)
= -$326,000.
(b) There is no simple answer here. Hedging is expected to decrease the dollar receipt by $326,000. If I were willing to sacrifice $326,000 or much more to eliminate exchange risk, I would hedge. If not, I would not. It depends upon the degree of my risk aversion.
(c) As I eliminate risk without sacrificing dollar receipt, I would be more similarly to hedge.