A small US exporting firm seeks your advice in managing the exchange rste exposu
ID: 2655184 • Letter: A
Question
A small US exporting firm seeks your advice in managing the exchange rste exposure on its foreign currency transsctions.They have just signed a contract in which they are selling a good to an Australian buyer.Invthe deal, they are to ship the goods today and a payment of AUD 2.5million will be received in 90days.The current market information is as follows:
Exchange Market Euro market Rates (annualised):
spot (USD/AUD) 0.8575 90 day AUD interest rates 5.450/5.850
Forward (USD/
AUD) 0.8536 f90days day USD interest rates 3.600/4.000 The market is ofering 90 day option on AUD against the UDS with strike price of USD 0.8000/AUD. The premia on these opyions are USD 0.0257 per AUD for a put and USD 0.0795 per AUD for a call.
a)Aescribe the forward contract you enter i to as a hedge of this exposure.Determine 7tge USD value of total cash flows the US firm will received at settlement.
and yhe US firmB)Describe the money mar3ket hedge for this situation.Determine the USD value of total cash flows the US firm will receive today if the firms cost of borrowing and lending is euro market rates for each currency.
c) Describe the simple(single) option contract you would enter into as a hedge of this exposure.Determine,in future value terms,the USD value of total cash flows the US firm would end up receiving at settlement in tge that they had to exercise the option.Assume its opportunity costs of funds are the euromarket rares in sach currency,respectivelyt rates 3.600/4.000
Explanation / Answer
Ans
Ans 1 Option 1 Enter in to forward agreement Amount 90 Days forward rate for USD/AUD 0.85 AUD receivable at end of 90 days 25,00,000.00 USD to be received at the end of 90 days under forward contract 21,34,000.00 Ans 2 Option 2 Enter in to money market hedge Borrow USD @ 4% to buy USD at spot rate Convert the AUD 2.5 Mn to USD at the spot rate 25,00,000.00 Spot rate 0.86 USD converted at spot rate( Borrowed money) 21,43,750.00 Invest the converted USD @ 3.6% Investment income= 2143750*3.6%*90/365 19,029.45 Realize the investment plus interest income after 90 days 21,62,779.45 Repay the loan with interest @ 4% Interest Expense=2143750*4%*90/365 21,143.84 Repay the loan with interest 21,64,893.84 Net Proceeds=AUD 2.5 Mn converted at spot rate+investment income-interest expense 21,41,635.62 Ans 3 Option 3 - Buy an Option contract to sell (Put option) AUD receivable 25,00,000.00 Exercise Price 0.80 Proceeds of option contract 20,00,000.00 Cost of put Option contract=2500000*.0257 64,250.00 Interest cost on the option contract=64250*4%890/365 633.70 Total Cost 64,883.70 Net Proceeds 19,35,116.30 Ans 4 Cost of a call option Cost of call Option contract=2500000*.0795 1,98,750.00 Interest cost on the option contract=198750*4%*90/365 1,960.27 Total Cost 2,00,710.27 Call option has a cost of 200,710 where as Put option has a cost of 64,883.70