Question

A company expects to make a payment of €1,000,000 to their vendor in Germany in six months.

The following information is available:

Spot rate today = $1.1800 $/€

Six-month Forward Rate = $1.22 $/€

Six-month Call Option premium, E=$1.18 $0.04

Six month Put option premium, E=$1.18 $0.03

Six-month Interest rate in U.S. 4% per annum

Amount € 1,000,000.00

a) Should the company be worried about the dollar depreciation or appreciating?

b) How should the company hedge the payment using options? Buy calls, sell calls, buy puts or sell puts?

c) Show the net payoffs after hedging with the recommended options. Assuming the spot price is

either $1.02/€, $1.18/€ or $1.25/€ at expiration?

d) Show the net payoffs using a forward hedge. Which hedge is better, forward or option?

Answer 1

Payable €1,000,000

a)Since it is payable in EURO, If dollar depreciates, more dollars will be required to pay 1000000 EUROs. Hence, the company should be worried about dollar depreciation.

b) Company should buy calls to hedge . Strike price of call $1.18/€. If the exchange rate goes up, there will be gain in Call Option which will offset loss in spot market.

c) OPTION MARKET HEDGING :

Premium to be paid=1000000*$0.04=$40,000

If the exchange rate goes up, the gain in call option will offset the increase in cost

Maximum Cost for this alternative: $40,000

S	A	B=A*1million	C	D=1million*(1.18-S)	E=B+C+D
Price at expiration per Euro	Call OptionPayoff per Euro	Total Payoff in Call Option	Cost of Option	Gain/(Loss) in Spot market	NET PAYOFF
$1.02	$0	$0	($40,000)	$160,000	$120,000
$1.18	$0	$0	($40,000)	$0	($40,000)
$1.25	$0.07	$70,000	($40,000)	($70,000)	($40,000)

FORWARD MARKET HEDGE :

Forward rate:$1.22/EURO

Enter into a forward contract to buy 1000000 EUROS

Amount to be paid after 3 months =$1.22*1000000=$1220000

Net Payoff=$1180000-$1220000=-$40000

CALL OPTION HEDGING IS BETTER, BECAUSE THERE WILL BE GAIN IF THE SPOT RATE FALLS.