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Why do we see a preference for the forward-market hedge over the money-market hedge?
This portion of the class can be expanded or limited depending on the guidance of the instructor during class. A discussion of parity conditions can be useful, but can also pull the class off track. The preference arises out of the unique borrowing costs presented to Baker. The bank affiliate in Brazil is charging a higher credit spread to Baker than in Baker’s domestic borrowing market. This is another important insight moment—imperfections in the markets will generate preferences.
5. With the forward or money-market hedge in place, can the company be completely sure there will be no exchange risk?
This discussion is quite important. The financial hedges are created under the assumption that the cash flow will be received by the customer on a specific date. There are, in fact, a number of residual risks that make the hedge less than perfect. This will come as a surprise to many students.
6. Should Baker accept the new order?
At first, the order appears to be unprofitable; however, the students can be pushed to think more carefully about the underlying economics and realize that, in fact, the order is still …show more content…
|Cost estimate |44,500 | |
| Realized profit relative to cost estimate |1,075 | |
| | | |
|Change in profit |(2,796) | |
|Percentage change in profit |−72.23% | |
| | | |
|Change in Exchange Rate | | |
|Budgeted exchange rate (US$/BRL) |0.4636 | |
|Realized exchange rate (US$/BRL) |0.4368 |
This portion of the class can be expanded or limited depending on the guidance of the instructor during class. A discussion of parity conditions can be useful, but can also pull the class off track. The preference arises out of the unique borrowing costs presented to Baker. The bank affiliate in Brazil is charging a higher credit spread to Baker than in Baker’s domestic borrowing market. This is another important insight moment—imperfections in the markets will generate preferences.
5. With the forward or money-market hedge in place, can the company be completely sure there will be no exchange risk?
This discussion is quite important. The financial hedges are created under the assumption that the cash flow will be received by the customer on a specific date. There are, in fact, a number of residual risks that make the hedge less than perfect. This will come as a surprise to many students.
6. Should Baker accept the new order?
At first, the order appears to be unprofitable; however, the students can be pushed to think more carefully about the underlying economics and realize that, in fact, the order is still …show more content…
|Cost estimate |44,500 | |
| Realized profit relative to cost estimate |1,075 | |
| | | |
|Change in profit |(2,796) | |
|Percentage change in profit |−72.23% | |
| | | |
|Change in Exchange Rate | | |
|Budgeted exchange rate (US$/BRL) |0.4636 | |
|Realized exchange rate (US$/BRL) |0.4368 |