Indiana Co. expects to receive 5 million euros in 1 year from exports, and it wa
ID: 2743556 • Letter: I
Question
Indiana Co. expects to receive 5 million euros in 1 year from exports, and it wants to consider hedging its exchange rate risk. The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Co. uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8 percent versus an annual interest rate of 5 percent in the eurozone. Put options on euros are available with an exercise price of $1.11, an expiration date of 1 year from today, and a premium of $.06 per unit. Estimate the dollar cash flows that Indiana Co. will receive as a result of using each of the following strategies:
a. unhedged strategy
b. money market hedge
c. call option hedge
What hedge is optimal?
Explanation / Answer
Calculation of Forward Rate
Spot Rate $1.10
US Interest Rate 0.08
Euro Interest Rate 0.05
p= 0.028571429
Forward Rate = $1.13
a. Unhedged strategy
Future Spot Rate $1.13
Amount of Euros to Convert 5,000,000
Cash flow $5,657,142
b. Money Market Hedge
Amount of Receivables 5,000,000
Interest Rate to borrow euros 0.05
Amount in euros borrowed 4,761,904
$ received from converting $5,238,095
U.S. deposit rate 0.08
$ accumulated after 1 yr $5,657,142
Cash flow $5,657,142
c. Put Option Hedge
Exercise Price $1.11
Future Spot Rate $1.13
Premium per Unit $0.06
Exercise Option? NO
Amount of Receivables 5,000,000
Received per Unit $1.07
Cash flow $5,357,142
The money market hedge and unhedged strategy achieve the same outcome, which is more favorable than the put option strategy