Bobs manufacturing has just signed a contract to buy equipment from Benz for Eur
ID: 2766215 • 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
Amount payable in future = Euro 5,000,000
Interest Rate to deposit in Euro = 4% or 1% per 3 months
Amount in Euro to be deposited = Euro 5,000,000 / (1+0.01)
Amount in Euro to be deposited = Euro 4,950,495
Convert Present value of payment using spot exchange rate of $1.13/euro
= $1.13 * 4,950,495
= $5,594,059
U.S borrowing rate = 9% or 2.25% per 3 months
$ accumulated after 3 months = $5,594,059 * (1.0225) = $5,719,925
Cash outflow today = $5,719,925
Exercise Price = $1.17
Future Spot Rate = $1.147
Premium per unit = $0.014
Exercise Call Option = Yes
Amount Of Payable = 5,000,000
Payment per unit = $1.133 ($1.147 - $0.014)
Cash outflow today = $5,665,000
Amount payable = 5,000,000
Forward rate = $1.147/euro
Cash outflow = $5,735,000 ($5,000,000 * 1.147)