Question

Indiana Company expects to receive 5 million euros in one year from exports. It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar cash flows received as a result of using the following strategies:

a) unhedged strategy

b)money market hedge

c)option hedge

The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Company uses the forward rate as a predictor of the future spot rate. The annual interest rate in the U.S. is 8% versus an annual interest rate of 5% in the euro zone. Put options on euros are available with an exercise price of $1.11, an expiration date of one year from today, and a premium of $.06 per unit. Estimate the dollar cash flows it will receive as a result of using each strategy. Which hedge is optimal?

Answer 1

Using interest rate parity theorem ,

Forward Rate = spot rate * (1+ interest rate in us country )/(1+interest rate in Euro zone )

  = $1.1 × [(1+0.8)/(1+0.5)] = $1.13

(A) Unhedged Strategy

= 5000000 ×1.13 = 5650000 Dollars

(B) Money Market hedge

Particluars		Amount
Amount to be received		5000000
Borrowing rate		0.05
Amount borrowed in euros	(5000000  / 1.05)	4761905
Amount received after conversion	(4761905 * 1.10)	5238095
Deposit rate		0.08
Amount received after a year	(5238095 * 1.08)	5657143 Dollars

(C) Call Option Hedge

Particluars	Amount
Exercise price	1.11
Forward rate	1.13
Premium per unit	0.06
Option exercised	No
Net rate per unit (1.13 - 0.06)	1.07
Amount received after a year (5,000,000 * $1.07)	5350000 Dollars

From the above calculations it was seen that ,the moneymarket hedge will results in highest net dollar cash flow . Hence that option is tenable to opt.