Question

ABC corporation has just sold equipment to a French company exports worth FF 80 million with payment due in three months. The spot rate is FF 7.4/$ and the 3 month forward rate is FF 7.5/$. Also assume: 3 month French interest rate 9.00% p.a. 3 month U.S. interest rate 4.00% p.a. 3 month call option on Francs at FF 7.5/$ (strike price) 3.0% premium 3 month put option on Francs at FF 7.5/$ (strike price) 2.4% premium a) How can ABC hedge this risk? b) Which alternative would you choose and why?

Answer 1

ABC Corporation is assumed to be a US-based company. and will have foreign currency (FF) receivables worth 80 million in 3 months time. The company has three options of hedging the exchange rate risk associated with the foreign currency receivables, namely hedging using a forward contract, hedging using options and implementing a money market hedge. The preferred option would be the one which provides the cheapest rate of exchange for the 80 millio FF receivables.

Option1: Forward Contract

Forward Rate = 7.5 FF/ $

Receivables Value in $ = R1 = 80 / 7.5 = $ 10.67 million

Option 2: Put Option

The option of choice is the put option and not the call option as the underlying asset, in this case, is the FF which is receivable and hence needs to be sold at a particular rate.

Put Premium = 2.4 % of the strike price = 0.024 x 7.5 = 0.18 FF

Strike Price = 7.5 FF / $

Effective Strike Rate = 7.5 + 0.18 = 7.68 FF/ $

Receivable Value in $ = 80 / 7.68 = R2 = $ 10.4167 million

Option 3: Money Market Hedge

- Borrow FF equal to the PV of the FF receivables which is (80 / 1.0075) = FF 79.4045 million

- Convert this borrowing into $ at the current exchange rate of 7.4 FF/$ to obtain (79.4045/7.4) = $ 10.73034 million

- Deposit this borrowing into an account earning the US interest rate of 4 % per annum for three months to yield (10.73034 x 1.0033) = $ 10.7657 million

- Payoff FF loan liability of 80 million with the receivables.

- Effective Exchange Rate = (Receivables / $ Deposit Value) = 80 / 10.7657 = 7.43 FF / $

Receivables Value in $ = 80 / 7.43 = R3 = $ 10.767 million

As among R1, R2 and R3, R3 is possesses the greatest value by providing the cheaperst effective exchange rate the same should be chosen.