Question

TEK wishes to hedge a EUR4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment from Olivetti is due in three months. TEK’s Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank has offered TEK the following quotes:

Spot rate	USD1.2000/EUR
3 month forward rate	USD1.2180/EUR
Three month euro interest rate	4.2% per year
3 month put option on euros at strike price of USD1.0800/EUR	3.4%
TEK’s weighted average cost of capital	9.8%

1. What are the costs of its payment hedging alternatives if it uses the forward and options market?

Answer 1

1. Do nothing and exchange euros for dollars at the end of 3 months

Amount of euro receivable = 4,000,000

If Spot rate in 3 months is the same as forward rate = 1.2180

us dollar proceeds receivable would be $4,872,000

Amount of Euro Receivable = 4,000,000

If Spot rate in 3 months is the same as Current spot rate = 4,800,000

2. Sell Euro Receivable at the 3 month forward rate

Amount of Euro Receivable = 4,000,000

Forward Rate = 1.2180

Us dollar proceeds receivable would be = $ 4,872,000

3. Buy a Put option on Euros

Amount of Euro Receivable = 4,000,000

Current Spot Rate = 1.2000

Premium on Put option = 3.400%

Cost of Put option = $ 1,63,200

if the spot rate at end of 3 months is less than strike rate the option is exercised yielding gross dollars of $ 4,800,000

Less Cost of option plus US $ interest on premium ($1,67,198.40)

Net Proceeds if options are exercised $4,632,801.60

Summary

1. Do nothing - Value $ 4,800,000 Risky

2. Sell Forward - Value $ 48,72,000 Certain

3. Buy Put option - Value $4,632,801.60 Minimum

If Tek want to play safe it should opt for Forward