Question

Chronos Time Pleces of Eoston exports watches to many coundries, tolling in local currencies to stores and distributars. Chronos prides itself on being financialy consenvatie. At least 70% of each individual transaction exposure is hedged, mostiy in the forward market, but occasionally. With option. Chronos' foreign exchange policy is such that the 70% hedge may be increased up io a 120% hedge if devaluation or depreciation appears. imminont. Chronos has just shipped to its major North American diatributor. It has issued a 90 -day invoice to its buyer for E1,550,000. The currant spot rale is $1.2221 ti, the 90-day forward rote is $1.22886. Chronos' treasurer, Manny Hemandez, has a very good track record in predicting oxchange rate movements. He eurrently belleves the eure will weaken against the dollar in the coming 90 to 120 doys. possibly to around $1.1693/6

a. Evaluate the hedging atiamatives for Chronos if Manny is right (Case 1:51,1693/E) and if Manny is wrong (Case 2:51.2527/6). What do you recornmend?
b. What does it mean to hedgo 1208 of a traneaction exposure?
c. What would be considered the most conservative transaction exposura management policy by a firm? How does Chronos compare?

Answer 1

a. If the euro weakens as predicted by Manny (Case 1: $1.1693/E), Chronos benefits from hedging at 120%, gaining $15,196.89. If Manny is wrong (Case 2: $1.2527/E), Chronos would have been better off without hedging, losing $14,166.15.

b. Hedging 120% of a transaction exposure means securing more than the full value of the exposure against potential exchange rate fluctuations, providing a surplus protection in case of adverse movements.

c. The most conservative transaction exposure management policy involves hedging beyond the actual exposure, ensuring a surplus protection against adverse currency movements. Chronos follows a conservative approach, hedging at least 70% and allowing flexibility to increase it to 120% when anticipating devaluation or depreciation.

Step-by-step explanation:

a. In Case 1, if the euro weakens as predicted by Manny to $1.1693/E, Chronos' 120% hedge would result in a gain. Calculating the gain by subtracting the forward rate ($1.22886) from the predicted rate ($1.1693) and multiplying it by the invoice amount (€1,550,000), the gain is $15,196.89. However, in Case 2, if Manny's prediction is wrong and the euro strengthens to $1.2527/E, Chronos would have been better off without hedging, incurring a loss of $14,166.15.

b. Hedging 120% of a transaction exposure implies protecting more than the total exposure. It provides an additional safeguard against adverse movements, ensuring a surplus protection beyond the actual value of the transaction.

c. The most conservative transaction exposure management policy involves over-hedging to mitigate risks further. Chronos' policy aligns with conservative practices by hedging at least 70% and allowing an increase up to 120% when anticipating devaluation or depreciation, demonstrating a proactive approach to risk management. This strategy ensures a significant level of protection against currency fluctuations, reflecting a prudent and conservative financial stance.