Indiana Co. expects to receive 5 million euros in 1 year from exports, and it wa

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

Explanation / Answer

Calculation of Forward Rate:

Option a: Remain Unhedged

$1.13

5,000,000

$5,657,142

Option b: Money Market Hedge

0.05

$5,238,095.24

0.08

$5,657,142

Option c: Put Option Hedge

$1.11

$1.13

5,000,000

$5,357,142

Money market hedge and unhedged strategy achieve the same outcome, which is more favorable than the put option strategy.

Spot Rate $1.10 U.S. Interest Rate 0.08 Euro Interest Rate 0.05 p 0.028571429 Forward Rate $1.10

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