Question

31. Problem 1 : Linden Company will receive 200,000 Canadian dollars (C$) in 90 days and is trying to determine whether or not to hedge this position. Linden has developed the following probability distribution for the Canadian dollar:

Possible Value of
Canadian Dollar in 90 Days	Probability
$0.54 $0.55	15% 15%
$ 0.57	20%
$ 0.58	25%
$ 0.59	25%

The 90-day forward rate of the Canadian dollar is $0.575. Call options on the Canadian dollar are available with a premium of $0.02 per unit and an exercise price of $0.56 per Canadian dollar. Put options are available with a premium of $0.01 and an exercise price of $0.57 per Canadian dollar.

Clearly show your work for:

A. Forward hedge: clearly show your work and answer for a forward hedge. Clearly state whether you are buying or selling the currency at the forward rate.

B. Option hedge: clearly state if you are using a call or put to hedge your risk. Fill in the below table. Show any additional work below the table. Cleary state your answer.

Possible Spot Rate	Option Premium per Unit	Exercise	Amount received per Unit	Total amount received	Probability

                                                                                                                                    Expected Receivable___________

C. Unhedged strategy: Fill in the below table. Show any additional work below the table. Clearly state the value of the unhedged strategy.

Possible Spot Rate	Receivable in foreign currency	if Firm Remains Unhedged	Probability

                                                                               Expected Receivable________________

D. Clearly state what the best alternative for Charleston Company is and WHY: forward hedge, option hedge or no hedge.

Answer 1

A]

Linden Company will receive C$200,000 in 90 days.

Linden Company needs to sell and C$ to convert the receipts into US$ in 90 days.

Therefore,  Linden Company should sell the C$ forward.

US$ received after 90 days = amount receivable in C$ * forward rate

US$ received after 90 days = C$200,000 * $0.575

US$ received after 90 days = $115,000

B]

Linden Company will receive C$200,000 in 90 days.

Linden Company needs to sell and C$ to convert the receipts into US$ in 90 days.

Linden Company needs to hedge against a fall in the S/C$ exchange rate.

Therefore, Linden Company needs to buy put options on the C$.

A put option will be exercised if the spot rate at expiry is lower than the option exercise price.

Amount received per unit = spot rate - premium (if option is not exercised)

Amount received per unit = exercise price - premium (if option is exercised)

The amounts are calculated as below :

Expected Receivable = sum of (probability of each spot rate * total amount received at that spot rate)

Expected Receivable = $113,500

C]

The amounts are calculated as below :

Expected receivable = $114,000

D]

The forward hedge is the best alternative as the expected receivable after 90 days is highest with this alternative