Bobs manufacturing has just signed a contract to buy equipment from Benz for Eur
ID: 2766214 • 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 Bobs needs to discount the €5,000,000 by the Euro zone 3-month borrowing rate is 6% in order to determine the Euros needed today €5,000,000/(1+(0.06 X(3/12))) €4,926,108.37 Spot exchange rate = $1.13 per Euro Euros need today in Dollars = €4,926,108.37 x $1.13 $5,566,502.46 This cost of $5,566,502.46 must be paid back in US dollars at an interest rate of 9%: Total cost of money market hedhe =$5,566,502.46 X (1+(0.09*(1/2))) $5,816,995.07 Total cost of the money market hedge. $5,816,995.07 2) Option Hedge €5,000,000 needs to be mutliplied by the premium price of $.022: Premium = €5,000,000 X .022 = $1,100,000 The principal amount then needs to be converted at the exercise price: Exercise price = €5,000,000 X $1.14 = $3,550,000 $5,700,000 Total cost of using call options hedging = premium + exercise price $6,800,000 3) Forward Hedge Total cost of forward hedge = €5,000,000 x $1.147 $5,735,000