Question

1. Your US Company has just purchased a large quantity of parts from a German company for 2.0 million Euros. Your company will make the payment of 2.0 million Euros in 90 days. The current Spot rate on the EUR is $1.14 ($1.14/1 EUR)  

Your company has assumed that the expected spot rate on the EUR in 90 days will be the    same as the spot price today (The expected change in the spot rate over the next 90 days is 0.0%). However, the standard deviation of the expected change in the spot rate is 8% per year (4.0% per 90 days). Remember that a 5% one-sided tail is approximately 1.65 standard deviations away from the mean. Assume this transaction is the only international transaction your company is engaged in.

1. What is the expected US dollar cost of the 2.0 million EUR paid in 90 days?

Expected US Dollar = $_______ _____________

2. Are you worried that the Euro will strengthen or weaken over the next 90 days if you leave the position “unhedged”

Worried that Euro will = (strengthen / weaken )

3. What is the 95% Value-at-Risk measured in US dollars for this transaction?

                        95% Value at Risk = $ ____________

Answer 1

The company has acquired an enormous quantity of parts from a German company for 2.0 million euros. The company makes a return of 2.0 million euros in 90 days.

The current spot rate is $1.14 ($1.14/1 EUR).

The company expected the spot rate will remain fixed for 90 days.

1. The expected cost of U.S. Dollar of 2 million Euro as spot rate is a constant 1 EUR = $1.14

2 billion EUR= $1.14 x 2 Billion = $2.28 Billion.

2. If the company is concerned about that Euro will strengthen them or weaken over 90 days if it left unhedged;- The change is the spot rate for 90 days is 4%,

To say: - 4% increase in the spot rate of a dollar in EUR = 1.14 x 4% = 0.0456

If the spot rate increased by 4%, then the new spot rate of 1 EUR= $1.14 + 0.0456 = 1.1856

And, if there is a decrease in spot rate of 4%. Then $1.14 - ($1.14 - 4%) = $1.0944,  $1.0944= 1 EUR.

If it increased the spot rate, then the company offers a more amount of 2.3712 (1.1856 x 2 Billion).

If it is unchanged, the spot rate of the company has to offer a sum of 2.28 Billion.

0.0912 Billion Dollar (2.3712 - 2.28) has to pay if it increases the spot price.

When there is a decrease in spot prices, the value of 2.0 Billion will be 2.1888 Billion ($1.0944 x 2).

The company has to pay $2.28 - 2.1888 = 0.0912 less. Hence, in the 2nd case the company is profitable, the company has to pay $0.912 Billion Dollar less. On the other hand, In the 1st case the spot price of the company increased and henceforth have to pay 0.0912, So the company so go for hedging.

3. The 95% VAR measured in the U.S. Dollar transaction:- The amount of the exposure= 2.0 Billion Dollar

Volatility of the Asset= 95.00%

Time = 90 days = 3 Months or 0.25 year (3 Month/12)

Confidence limit= 4.00 Standard deviation

The value of the risk is (2.0 Billion x 95% x (0.25) ^0.5 x 4.00) = 3.80 Billion Dollar.