Question

Bobcat Company.  Bobcat​ Company, U.S.-based manufacturer of industrial​ equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won7,900 million.​ Won1,000 million has already been​ paid, and the remaining Won6,900 million is due in six months. The current spot rate is Won1,103​/$, and the​ 6-month forward rate is Won1,163​/$. The​ 6-month Korean won interest rate is 17​% per​ annum, the​ 6-month U.S. dollar rate is 4.5​% per annum. Bobcat can invest at these interest​ rates, or borrow at​ 2% per annum above those rates. A​ 6-month call option on won with a Won1,200​/$ strike rate has a 4.1​% ​premium, while the​ 6-month put option at the same strike rate has a 3.4​% premium.

Bobcat can invest at the rates given​ above, or borrow at​ 2% per annum above those rates.​ Bobcat's weighted average cost of capital is 12​%. Compare alternate ways below that Bobcat might deal with its foreign exchange exposure.  

a. How much in U.S. dollars will Bobcat pay in 6 months without a hedge if the expected spot rate in 6 months is assumed to be Won1,103​/$? Won1,163​/$?

b. How much in U.S. dollars will Bobcat pay in 6 months with a forward market​ hedge?

c. How much in U.S. dollars will Bobcat pay in 6 months with a money market​ hedge?

d. How much in U.S. dollars will Bobcat pay in 6 months with an option hedge if the expected spot rate in 6 months is assumed to be less than Won1,200​/$? To be Won1,300​/$?

e. What do you​ recommend?

Answer 1

a) Amount paid in US dollars if expected spot rate is Won 1103/$

= Won 6900 million / ( Won1103/$)

=$6.255666364 million or $6,255,666.36

Amount paid in US dollars if expected spot rate is Won 1163/$

= Won 6900 million / ( Won1163/$)

=$5.932932072 million or $5,932,932.07

b) With a 6-month forward rate is Won1163​/$, the exchange rate to convert $ to Won can be fixed at Won1163/$ (Forward hedge),

Amount paid in US dollars with forward hedge

= Won 6900 million / ( Won1163/$)

=$5.932932072 million or $5,932,932.07

c) With money market hedge, Bobcat borrows $ today for 6 months and converts them to Won today, and invests for 6 months in Won in such a way that Won 6900 million is available after 6 months

Amount in Won to be deposited today = Won 6900 million/ (1+0.17*6/12) = Won 6359.447005 million

Amount of $ to be borrowed today = Won 6359.447005 million/ ( Won1103/$) =$5.76559119 million

Maturity amount of $ borrowing (at 6.5% ) to be paid after 6 months

=5.76559119 million * (1+0.065*6/12) =$5.952972831 or $5,952,972.83

d)

Since Bobcat requires Won after 6 months, they will have to purchase Call options to hedge their exposure

Premium of call options in $ per Won = 1/1200 * 4.1% = $0.000034167 per Won

So, upfront call option premium for purchasing Won 6900 million = $0.000034167 per Won * Won 6900 million = $235750

if the expected spot rate in 6 months is assumed to be less than Won1,200​/$, the call option will be exercised

BobCat will pay= Won 6900 million / ( Won1200/$)

=$5.75 million or $5,750,000

plus the cost of premium at cost of capital for 6 months = 235750*(1+0.12*6/12) = $249895

Thus, total amount paid by Bobcat = $5750000+$249895 = $5999895

if the expected spot rate in 6 months is assumed to be Won1,300​/$, the call option will not be exercised

BobCat will pay= Won 6900 million / ( Won1300/$)

=$5.3076923 million or $5,307,692.31

plus the cost of premium at cost of capital for 6 months = 235750*(1+0.12*6/12) = $249895

Thus, total amount paid by Bobcat = $5307692.31+$249895 = $5557587.31

  

e) The forward hedge is the recommended hedge as the amount paid in US Dollars is the least in this case.