Backward Industries - a US based MNC - projects it will receive 50,000 Brazilian Real (BRZ)...

Backward Industries - a US based MNC - projects it will receive 50,000 Brazilian Real (BRZ) from a Brazilian customer in 3 months, however, it is only 50% certain that the money will actually be paid out as the customer is currently in financial distress. Backward wants to reduce its exposure to foreign exchange rate risk. Which of the following is the best option for Backward in this situation?

	A.	Tell your Brazilian customer not to pay
	B.	Enter into a forward contract to buy Brazilian Real
	C.	Buy a put option on the Brazilian Real
	D.	Do not hedge this exposure
	E.	Buy a put option on the US Dollar
	F.	Buy a call option on the Brazilian Real

Expert Solution

C. Buy a put option on the Brazilian Real, is the best option for Backward in this situation.

Explaination

Backward Industries are predicting to receive payment from an overseas customer in Brazil. I.e. 50000*50%=25000 BRZ

Buying put option on BRZ is the best option because it reduces the risk of the falling BRZ and allow the benifit of BRZ appreciation to be taken.

Why other options are not right.

A. Tell Your Brazilian Customer not to pay.

Explanation:- No company will deny a payment just to avoid exchange rate risk.

B. Enter into an forward contact to buy Brazilian real.

Explanation :- Forward contracts reduce the exchange rate risk but they also eliminate the probability of any exchange rate gains.

D. Do not Hedge this exposure.

Explanation :- Hedging is the best option available.

E. Buy a put option on US dollar

Explanation:- Buying a put option on US Dollar does not reduce the risk of BRZ flactuation.

F. Buy a call option on Brazilian Real

Explanation:- Increase in BRZ valuation is not the risk. The decrease in BRZ is the risk therefore we should take a put option.

jeff jeffy answered 2 years ago

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