Question

Information:

Plains States Manufacturing has just signed a contract to sell agricultural equipment to Boschin, a German firm, for euro 1,250,000. The sale was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.

∙     The spot exchange rate is $1.40/euro

∙     The six month forward rate is $1.38/euro

∙     Plains States' cost of capital is 11% p.a.(or 5.5% for 6 months)

∙     The Euro borrowing interest rate is 9% p.a.(or 4.5% for 6 months)

∙     The Euro lending interest rate is 7% p.a.(or 3.5% for 6 months)

∙     The U.S. borrowing interest rate is 8% p.a. (or 4% for 6 months)

∙     The U.S. lending interest rate is 6% p.a. (or 3% for 6 months)

∙     December put options for euro: size of a contract euro 625,000; strike price $1.38, premium price is 1.5%. Use current Spot exchange rate, not strike price to calculate premium.

∙     Plains States' forecast for 6-month spot rates is $1.43/euro

∙     The budget rate, or the lowest acceptable sales price for this project, is $1,700,000 or $1.36/euro

Question:

1.) How would I set up and calculate a money market hedge (please include calculation)?

2.) How would I set up and hedge with an option (please include calculation)?

Answer 1

# Money market hedge-

Total receivalbe after 6 moth in Decemeber	Euro 1250000
6 month Euro Borrowing Rate -	4.5% for 6 month
Step- 1 Euro to be borrowed today so that the euro borrowed along with the interest will be fully repaid by the Euro receivable after 6 month = Euro 1250000/ (1+4.5%) =Euro 1196172	Euro 1196172
Step-2 Convert the Euro borrowed today to $ at totays spot rate Euro 1 = $1.40 =Euro 1196172 * $1.40 per euro =$1674641	$1674641
Step -3 Deposite the $ received @3% for 6 months Amount of $ received after 6 month =$1674641 + ($1674641*3%) =$1724880	$1724880
Step-4 after 6 month euro amount borrowed will be Euro 1250000 which will be fully repaied by the Euro Received after 6 months.
Hence total $ to be recive after 6 month	$1724880

# Option Market Hedge-

Option type	Put option (Right to sell)
One option contract	Euro 625000
Total Euro Exposure	Euro 1250000
No of contract to be taken	=Euro 1250000/ Euro 625000 = 2 contracts
Option to be taken	BUY 2 PUT OPTION TO GET THE RIGHT TO SELL Euro 1250000 at Strike price $1.38 per Euro
Put option premium= =Euro 1250000* $1.40 per Euro * 1.5% =$26250 (Plains should borrow $26250 today to pay the premium@4% for 6 months	$26250
$ Amount to be received after 6 month under exercise of put option = = Euro1250000* $1.38 per Euro =$1725000	$1725000
$ amount borrowed for payment of premium will be repaid after 6 months =$26250 + ($26250*4%) =$27300	$27300
Net $ to be recived under option hedging	=$1725000-$27300 =$1697700 Note- How ever if at the end of 6 months the exchange rate is more than $1.38 per Euro then the investor will ot exercise his put option as hen get more $ per Euro by selling the Euro in the market.

Opinion- Amount received under money market hedge is more than the option market hedge.