Bobcat Company, US-based manufacturer of industrial equipment, just purchased a

ID: 2778455 • Letter: B

Question

Bobcat Company, US-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and bolts for heaby equipment. The purchase price was Won 7,500 million. Won 1,000 million has already been paid, and the remaining Won 6,500 million is due in six months. The current spot rate is Won 1,110/$, and the 6-month forward rate is Won 1,175/$. The 6-month Korean won interest rate is 16% per annum, the 6-month U.S dollar rate is 4% annum. Bobcat can invest at these interest rates, or borrow at 2% per annum above those rates. A 6-month call option on won with a Won 1,200/$ strike rate has a 3.0% premium, while the 6-month put option at the same strike rate has a 2.4% premium.

Bobcat can invest at the rates given above or borrow at 2% per annum above those rates. Bobcat's weighted average cost of capital is 10%. Compare alternate ways that bocat might deal with its foreign exposure. What do you reccomend?

Explanation / Answer

Forward Hedge Contract

Liability to be settled in Korean Won

6500 million

Forward Rate

1175/$

Cash outflow in USD

5531914.89 (6500 million/1175)

Present Value of Cash Outflow

5274473.89

5531914.89/(1.1)0.5

Money Market Hedge

Borrow in US $ @ 6%, an amount equal to Korean Won ( at spot rate), which if invested at 16% p.a. will yield Won 6500 million in 6 month.

Hence, Won required to be invested (6500million/(1+(0.16*6/12)))

6018518519

Amount to be borrowed (6018518519/1110)

5422088.76

Amount paid after 6 months (5422088.76*(1+(0.06*6/12)))

5584751.42

Present Value of Cash Outflow (5584751/(1.1)0.5)

5324851.55

Options

Call Premium

36 Won

Put Premium

28.8 Won

Strike Price

1200/$

Since the strike price is more than forward rate, Call Option won't be exercised. Secondly, the payment is required to be made in Korean Won, hence Put Option is not feasible as one needs to pay in Won.

Hence, it is advisable to go for Forward Contract as the outflow is lowest under that option.