Question

1. Oregon Transportation Inc. (OTI) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €2,500,000. The purchase 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 euros rather than dollars, OTI 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 $1.1740/€
   • The six month forward rate is $1.1480/€
   • OTI’s cost of capital is 12% per annum
   • The Euro zone 6-month borrowing rate is 7% per annum (or 3.5% for 6 months)
   • The Euro zone 6-month lending rate is 5% per annum (or 2.5% for 6 months)
   • The U.S. 6-month borrowing rate is 6% per annum (or 3% for 6 months)
   • The U.S. 6-month lending rate is 4.5% per annum (or 2.25% for 6 months)
   • December put options for €625,000; strike price $1.18, premium price is 1.5%
   • OTI’s forecast for 6-month spot rates is $1.19/€
   • The budget rate, or the highest acceptable purchase price for this project, is $2,975,000 or $1.19/€ ($2,975,000/€2,500,000)

Q.1) OTI chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be __________.

Q.2)

1. Using the information provided in question 29, OTI 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.

Q.3)

1. Again, using the information provided in question 29, OTI chooses to hedge its transaction exposure by the money market hedge. Given the OTI's cost of capital, the future value of the U.S. dollar proceeds at the end of 6 months to pay off the accounts payable will be __________.

Answer 1

Q.1) OTI chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be = Forward rate x amount payable = $1.1480/€ x €2,500,000 = $  2,870,000

Q.2) Using the information provided in question 29, OTI would be better off by an amount equal to = (Forecast spot rate - Forward rate) x Amount = (1.19 - 1.1480) x 2,500,000 = $ 110,500 with a forward hedge than if they had not hedged and their predicted exchange rate for 6 months had been correct.

Q.3) Again, using the information provided in question 29, OTI chooses to hedge its transaction exposure by the money market hedge. Given the OTI's cost of capital, the future value of the U.S. dollar proceeds at the end of 6 months to pay off the accounts payable will be $ 3,035,220.

Euros needed today (A/P discounted 180 days) = 2,500,000 / (1 + The Euro zone 6-month lending rate for 6 months) = 2,500,000 / (1 + 2.5%) = Euro  2,439,024

Cost in dollars today (Euro to $ at spot rate) =  2,439,024 x $1.1740/€ = $  2,863,415

factor to carry dollars forward 180 days = 1 + WACC x 180 / 360 = 1 + 12% / 2 = 1.06

Cost in dollars in six-months ($ carried forward 180 days ) = $  2,863,415 x 1.06 = $  3,035,220