Plains States Manufacturing has just signed a contract to sell agricultural equi
ID: 2794256 • Letter: P
Question
Plains States Manufacturing has just signed a contract to sell agricultural equipment to Boschin, a German firm, for EUR 1,250,000. The sale was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in EURs rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
The spot exchange rate is USD1.40/EUR
The six-month forward rate is USD1.38/EUR
Plains States' cost of capital is 11%
The EUR zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
The EUR zone 6-month lending rate is 7% (or 3.5% for 6 months)
The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
The U.S. 6-month lending rate is 6% (or 3% for 6 months)
December put options for EUR 625,000; strike price USD1.42, premium price is 1.5%
Plains States' forecast for 6-month spot rates is USD1.43/EUR
The budget rate, or the lowest acceptable sales price for this project, is USD1,075,000 or USD1.35/EUR
Plains States would be ________ by an amount equal to ________ with a forward hedge than if they had not hedged and their predicted exchange rate for 6 months had been correct.
A. better off; USD62,500Explanation / Answer
Taking forward cover on EUR 1,250,000 at 6m forward rate of $1.38
Total Receivable taking forward cover = 1,250,000 * 1.38 = $1,725,000
Total Receivable by using predicted rate = 1,250,000 * 1.43 = $1,787,500
Plains states would receive more by using the predicted rate
Loss by taking forward contract = $1,787,500 - $1,725,000 = $62,500
Therfore answer to the question
C. Plains States would be worse off by an amount equal to $62,500 with a forward hedge than if they had not hedged and their predicted exchange rate for 6 months had been correct.