Question

Bobcat​ Company, U.S.-based manufacturer of industrial​ equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won8,000 million. Won1,000 million has already been​ paid, and the remaining Won7,000 million is due in six months. The current spot rate is Won1,104/$ and the​ 6-month forward rate is Won1,162/$. The​ 6-month Korean won interest rate is 15% per annum, the 6-month U.S. dollar rate is 3.5% per annum. Bobcat can invest at these interest rate, or borrow ar 2% per annum above those rates. A 6-month call option on won with a Won 1,200/$ strike rate has a 3.2% premium, while the 6-month put option at the same strike rate has a 2.5% 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 11%. Compare alternate ways below that Bobcat might deal with its foreign exchange exposure.  

a.) How much in U.D Dollars will Bobcat pay in 6 months without a hedge if the expected spot rate in 6 months is assumed to be (1) Won1,104/$? (2) Won 1,162/$?

b) How much in U.S. dollars will Bobcat pay in 6 months with a forward market​ hedge?

c) How much in U.S. dollars will Bobcat pay in 6 months with a money market​ hedge?

d) How much in U.S. dollars will Bobcat pay in 6 months with an option hedge if the expected spot rate in 6 months is assumed to be less than (1) Won1,200/$ (2) To be 1,300/$

e) What do you​ recommend?

Answer 1

a]

Payment in USD without hedge =  Won 7,000 million / expected spot rate in 6 months

[1]   Won 7,000 million / Won 1,104 = $6,340,580

[2]   Won 7,000 million / Won 1,162 = $6,024,096

b]

Payment in USD with forward hedge =  Won 7,000 million / 6-month forward rate

Payment in USD with forward hedge =  Won 7,000 million / Won 1,162 = $6,024,096

c]

To pay Won 7,000 million in 6 months, the amount of Won deposit to make today is calculated as :

Won 7,000 million / (1 + Korean Won Deposit Interest Rate)^6/12

the amount of Won deposit to make today =  Won 7,000 million / (1 + 15%)^6/12 = Won 6,527,533,658

To make the won deposit, the amount of USD required today =  Won 6,527,533,658 / current spot rate

the amount of USD required today =  Won 6,527,533,658 / Won 1,104 = $5,912,621

The amount of USD to repay at the end of 6 months =   $5,912,621 * (1 + USD borrowing rate)^6/12

amount of USD to repay at the end of 6 months =   $5,912,621 * (1 + 5.5%)^6/12

amount of USD to repay at the end of 6 months = $5,756,438

d]

A put option will be purchased as Bobcat needs to sell dollars and buy Won in 6 months. Premium paid = Won 1,200 * 2.5% = Won 30

[1] If the spot rate in 6 months is less than Won 1,200/$, the put option will be exercised. This is because the USD can be sold at a higher rate at the option strike price than at the spot rate

Amount in USD to pay = Won 7,000 million / (strike price + option premium)

Amount in USD to pay = Won 7,000 million / (Won 1,200 + Won 30) = $5,691,057

[2] If the spot rate in 6 months is Won 1,300/$, the put option will not be exercised. This is because the USD can be sold at a higher rate at the spot rate, than at the option strike price

Amount in USD to pay = Won 7,000 million / (spot price - option premium)

Amount in USD to pay = Won 7,000 million / (Won 1,300 - Won 30) = $5,511,811

e]

It is recommended to buy the put option as the amount to pay in USD is lowest for the option hedge