Kenneth R. Szulczyk
number, $2,500, and equals - 1 ,666.66? A negative indicates the exchange rate fluctuations
cancel out the changes in rent. Consequently, you cannot use a forward contract in this case
because you do not have economic exposure.
Table 2. The is the Correct Hedge for Case 1
State Forward Price Exchange Rate (S) Yield
1 $1.25 / 1 € $1.00 / 1 € (1.25−1.00)×800 €= $ 200
2 $1.25 / 1 € $1.25 / 1 € (1.25−1.25)×800 €= $0
3 $1.25 / 1 € $1.50 / 1 € (1.25−1.50)×800 €= -$ 200
Total $0Table 3. Renting out your Condo for Case 2
State Probability Rent (€) Exchange Rate (S) Rent (P)
1 1/3 2 , 500 € $1 / 1 € $2, 500
2 1/3 2, 000 € $1.25 / 1 € $2,5 00
3 1/3 1,666.67 € $1.5 / 1 € $2, 500We, finally, examine the last case in Table 4. You charge the same rent, 2,000 € per month
for Case 3 regardless of exchange rate changes. Once you calculate the rent in U.S. dollars, the
exchange rate and rent amount move in the same direction. However, the equals 0 in this case
because the rent in euros does not vary. Consequently, you could hedge against the exchange
rate risk by purchasing a forward for 2,000 € and not the amount for the . By deciding to
charge the same rent, you can use a forward to protect this amount.
Table 4. Renting out your Condo for Case 3
State Probability Rent (€) Exchange Rate (S) Rent (P)
1 1/3 2,0 00 € $1.00 / 1 € $2.0 00
2 1/3 2,000 € $1.25 / 1 € $2,500
3 1/3 2, 000 € $1.50 / 1 € $3,0 00Condominium example was simple but difficult to do in practice. Thus, international firms
can use five techniques to reduce its economic exposure.
Technique 1: A company reduces its manufacturing costs by shifting production to low-
cost countries. For example, the Honda Motor Company produces high-quality cars, trucks, and
motorcycles in factories, located in Brazil, Canada, China, India, Indonesia, Japan, Pakistan,
Thailand, United States, and other countries. If the Japanese yen appreciates relative to the other
currencies and raises Honda's production costs, subsequently, Honda can shift its production to
its other facilities, scattered across the world.