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Lignum Co regularly trades with companies based in Zuhait, a small country in South America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million,. Itis expecting full payment for the machinery in four months. Although there are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-counter derivative products.
The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 8·5%plus 25 basis points and the French base rate of 2·2% less 30 basis points.
Alternatively, with the second derivative product Lignum Co can purchase either Euro call or put options from MedesBank at an exercise price equivalent to the current spot exchange rate of ZP142 per €1. The option premiums offered
are: ZP7 per €1 for the call option or ZP5 per €1 for the put option.please help me how to find the 4 months forward rate
Because the question says that the forward rate is determined by the Zuhait and French interest rates, then it is calculated using the interest rate parity formula that is given on the formula sheet.
The Zuhait interest rate is 8.5% + 0.25% = 8.75% (but this is per annum and so needs dividing by 3 to get interest for 4 months).
The French interest rate is 2.2% – 0.3% = 1.9% (but again needs dividing by 3)Hello sir, in this question I don’t understand how the exposure works. 40% of current assets are receivables and relate to sales made to lignum Co in euro…
The answer shows 60% is exposed? How? I think I know the answer but would like you to clarify
There’s a risk of devaluation of ringgit which is the subsidiary’s currencyThanks
The 40% that it is euros is OK, it is the other 60% that is in ringgit’s that is at risk if the ringgit devalues.
Oh so that’s the reason! Quite silly of me theorising that it was due to the company being a subsidiary, and that it created a natural hedge. Never paid attention to the euro being the host currency 😛
Thanks sir!
And about a week ago I was explaining the same thing to some student that same currencies don’t need to be hedged there’s no exposure.
Exam pressure I guess 🙂
Sir,
In part (a) iii, Why is it that Non-Current asset is 100% Exposure? I thought there will be no exposure since it is owned by the Namel Co, and does not involve cash conversion from Maram to Euro.
I can’t figure out the reason behind that, please help.
Thank you
It is only in case 2 that this is relevant, and in case 2 we are concerned with translation exposure which is the fact that the SOFP of Namel is all stated in MR’s and will need converting to Euros when Lignum prepares its consolidated SOFP.
As the exchange rate changes, then so to will the value of the non-current assets when converted to Euros.Translation exposure is not related to transfers of cash (and is therefore usually of less interest to the financial manager) – it is simply the fact that the value of the assets when converted will change as the exchange rate changes.
Good Day
Gross income from option = ZP140,000,000/142 = € 985,915
Cost
€ 985,915 x ZP7 = ZP6,901,405
In € = ZP6,901,405/142 = € 48,601Could you please explain this part?
The question says that the cost of the option is ZP7 per $, so to buy an option on €985,915 will cost 985,915 x 7 = ZP6,901,401.
We need to know the cost of the option in €’s, and therefore will divide by the spot rate of ZP142 per € in order to get the cost in €’s.
whats the formula used to calculate cost of capital in part (b) black sholes bit of the question
The exam question does not have anything about Black Scholes in it!
(I can only think that you are looking at it in a Revision Kit and that they have added an extra bit themselves – but there is nothing in the actual exam question, and so I cannot help you.)
Hi john
May I know why are we only borrow the cost €48601 but not the full amount €985915 which brought the total cost to €49200?They are not borrowing the full amount – they will convert the full amount when they receive it.
What they are borrowing is the money that needs to be paid for the option – the option premium has to be paid immediately.
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