Plains States Manufacturing has just signed a contract to sell agricultural equi
ID: 2794262 • 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 could hedge the EUR receivables in the money market. Using the information provided, how much would the money market hedge return in six months assuming Plains States reinvests the proceeds at the U.S. investment rate?
A. USD 1,674,641Explanation / Answer
Money Market Hedge
In the following steps we will identify the assets (Receipt) and liability (Loan) and then borrow currency to the extent of present value of loan. Then we convert receipt at spot rate and invest into foreign currency (here it is in U.S (USD($))).
IDENTIFY : EUR Assets (Receipt)
CREATE : EUR Liability (Loan)
BORROW : Borrow EUR (home currency) to the extent of present value (PV) of foreign loan (USD $)
So, PV EUR 1,250,000 @ 4.50% for 6 months
= 1,250,000/(1+ 4.50%)
= 1,250,000/(1 + 0.045)
= 1,250,000/1.045
= EUR 1,196,172.25
CONVERT : Sell 'x', EUR borrow and convert into USD ($) at Spot Rate (here, Spot Rate for EUR is relevant = USD1.40/EUR)
1 EUR = USD ($) 1.40
EUR 1,196,172.25 = ? USD ($)
Therefore, EUR 1,196,172.25 x USD ($) 1.40
= USD ($) 1,674,641.15
INVEST : Invest USD ($) 1,674,641.15 @ 3.0% (lending rate) for 6 months
Amount received by investing at the end of 6 months will be -
= USD ($) 1,674,641.15 x (1 + 3.0%)
= USD ($) 1,674,641.15 x (1 + 0.03)
= USD ($) 1,674,641.15 x 1.03
= USD ($) 1,724,880.38
= USD ($) 1,724,880 (rounded off)
The money market hedge return in 6 months will be USD ($) 1,724,880 so the correction option is C.