Bobs manufacturing has just signed a contract to buy equipment from Benz for Eur
ID: 2765770 • Letter: B
Question
Bobs manufacturing has just signed a contract to buy equipment from Benz for Euro 5,000,000
The purchase was made in April with payment due three months later in July
Bobs is considering hedging strategies to reduce the exchange rate risk arising from the purchase.
To help the CEO make a hedging decision you, Director of Finance, have gathered the following information.
- The spot exchange rate is $1.13/euro
- Bobs weighted cost of capital is 12%
- The Euro zone annual borrowing rate is 6%
- The Euro zone annual investment rate is 4%
- The U.S annual borrowing rate is 9%
- The U.S annual investment rate is 7%
- July put options for Euro 5,000,000, strike price $1.17, premium price is $0.022/euro
- July call options for Euro 5,000,000, strike price $1.17, premium price is $0.014/euro
- July forward rate on Euros is $1.147/euro
1. What is the total cost ($) for the Euro 5,000,000 payment with a money market hedge in July?
2. What is the total cost ($) for the Euro 5,000,000 payment with an option hedge in July if the exchange rate become $1.14/euro?
3. What is the total cost ($) for the Euro 5,000,000 payment with a forward hedge in July if the exchange rate become $1.14/euro?
Explanation / Answer
1. Money Market hedge
Amount Payable
5,000,000
Interest Rate to Invest
4% or 0.04
Amount in euros to be invested today
4,807,692.31
$ to paid today
5,432,692.31
U.S borrow rate
9% or 0.09
$ accumulated after I year
5,921,634.62
Cash out flow today
5,921,634.62
2.Call Option Hedge
Exercise Price
$1.17
Future Spot price
$1.14
Premium per unit
$0.01
Exercise Call option
yes
Amount of Payable
5,000,000
Paid per unit
1.154
Cash outflow today
5,774,634.00
3.Forward hedge
Forward rate
$1.15
Amount of euros to convert
5,000,000
Cash outflow today
5,735,000
Forward Hedge is better, because of its minimum or lower outflow today
1. Money Market hedge
Amount Payable
5,000,000
Interest Rate to Invest
4% or 0.04
Amount in euros to be invested today
4,807,692.31
$ to paid today
5,432,692.31
U.S borrow rate
9% or 0.09
$ accumulated after I year
5,921,634.62
Cash out flow today
5,921,634.62
2.Call Option Hedge
Exercise Price
$1.17
Future Spot price
$1.14
Premium per unit
$0.01
Exercise Call option
yes
Amount of Payable
5,000,000
Paid per unit
1.154
Cash outflow today
5,774,634.00
3.Forward hedge
Forward rate
$1.15
Amount of euros to convert
5,000,000
Cash outflow today
5,735,000
Forward Hedge is better, because of its minimum or lower outflow today