Question

A computer software development company in the U.S. exports its software to the euro zone. The company’s European distributor asks and the company agrees to receive payments in euros (€). The distributor has just ordered a shipment that is priced in euros at today’s dollar equivalent of $28,150,000 for delivery and settlement in three months. The U.S.-based company is particularly worried about a high degree of uncertainty surrounding the euro exchange rate against the dollar. It decides to consider whether to hedge. Consulting with a NY bank, the company is advised that there are four different ways it can accomplish the hedge: Through a forward contract, a futures contract, an option contract, and through a money market hedge. The following information is available:

Spot                                         $1.1260/€

3-month forward                       $1.1220/€

6-month forward                       $1.1360/€

3-month futures                        $1.1215/€

90-day call option #1                 $ 1.1280/€ strike; $ 0.0030/€ premium

90-day put option #1                 $ 1.1280/€ strike; $ 0.0050/€ premium

180-day call option #2               $ 1.1290/€ strike; $ 0.00820/€ premium

180-day put option #2                $ 1.1290/€ strike; $ 0.00980/€ premium

90-day dollar interest rate          4.40% per annum (deposit)        6.40% per annum (loan)

90-day euro interest rate            3.60% per annum (deposit)        5.60% per annum (loan)

1. Specify which hedging instruments (from the above list) you should look into.

Answer 1

	The amount receivable under each of the hedging
	alternatives should be calculated.
	Euro value of the receivable = 28150000/1.1260 =	€        2,50,00,000
1]	Forward contract:
	Amount receivable = 25000000*1.1220 =	$        2,80,50,000
2]	Futures:
	Amount receivable = 25000000*1.1215 =	$        2,80,37,500
3]	Call option:
	Amount receivable under the call option = 25000000*1.1280 =	$        2,82,00,000
	Less: Future value of option premium = 25000000*0.0030*(1+0.064/4) =	$                  76,200
	Net amount receivable [minimum]	$        2,81,23,800
4]	MMH:
	The strategy is to create an euro liability which
	will have a maturity value of Euro 25000000 in
	90 days, by borrowing in Euros now and then
	converting it inot $ at the current spot rate and
	further investing it in $ for 3 months.
	Amount to be borrowed in euros for 90 days = 25000000/(1+0.056/4) =	$        2,46,54,832
	Dollar equivalent to be deposted for 90 days = 24654832*1.1260 =	$        2,77,61,341
	Maturity value of the deposit = 27761341*(1+0.044/4) =	$        2,80,66,716
	On the 90th day, the euro receivable of 25000000
	will be realized and the euro loan with a maturity
	value of 25000000 will be paid off.
	The dollar deposit will mature, which will be
	encashed to get its maturity value of $28,066,716.
	Amount receivable under the MMH =	$        2,80,66,716
5]	As the amount receivable under the call uption is
	the highest, it should be preferred.