ABC Corportion has 90-day payables of Euro 350,000. The following info is availa
ID: 2721111 • Letter: A
Question
ABC Corportion has 90-day payables of Euro 350,000. The following info is available: Spot rate of the Euro: $1.20 per Euro 90-day forward rate: $1.15 per Euro 90-day interest rates are as follows: 90-day deposit rate US = 5% Euro = 5% 90-day borrowing rate US = 7% Euro = 7% A call option on Euro that expires in 90 days has an exercise price of $1.20 and has a premium of $0.03. A put option on Euro that expires in 90 days has an ecercise price of $1.20 and has a premium of $0.02, The Euro spot rate in 90 days is forecasted to be: Possible Rate $1.15 and Probability of 30% Possible Rate $1.10 and Probability of 70% ABC Corporation is considering 1) a forward hedge 2) a money market hedge 3) an option hedge and 4) remaining un-hedged You have been hired as a consultant to decide on the best possible hedge. Which one of the alternatives would you recommend and why?
Explanation / Answer
calculation of the amounts payable in the alternatives 1 forward hedge amount payable euro 350000 forward rate $1.15 amount payable in forward rate euro 350000 * 1.15 amount of dollar payable $402,500 2 money market hedge since the corporation have a liability obligation in euro create a asset amount in euro by investing the amount in euro today at the interest rate in euro 7 % which will mature 350000 in 90 days interest rate for 90 days in euro 7 % * 90 /360 interest rate for 90 days in euro 1.75% amount of euro need to be invested to create a asset 350000 / 1.0175 amount of euro need to be invested to create a asset 343980.34 asset of 343980.30 in euro have to be created by borrowing the amount in dollars at 7 % at the spot exchange rate in dollar amount spot exchange rate 1.2 dollars amount conversion 343980.30 * 1.20 dollars amount conversion 412776.36 interest rate for 90 days 7 % * 90/ 360 interest rate for 90 days 1.75% interest amount 412776 * 1.75 % interest amount 7223.58 total amount payable 412776.40 +7223.58 total amount payable $420,000 3 at option hedge since the corporation have to pay euro it have to take the call option premium payable 350000 * 0.03 premium payable 10500 expected spot rate 90 days 1 1.15 * 30 % 0.345 2 1.10 * 70 % 0.77 1.115 expected spot rate 90 days 1.115 since the call option exercise price is 1.20 and the expected price of dollar is 1.115 which is less than the call option price the corporation will not exercise the call option corporation will buy the euro at 1.115 amount payable 350000 * 1.115 amount payable 390250 premium paid 10500 total amount payable $400,750 4 remaining un hedged amount of euro payable 350000 expected spot rate in 90 days 1.115 total amount payable 350000 * 1.115 total amount payable $390,250 hence the corporation chose the remaining un hedged the option since amount payable is less in this alternative