Question

Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes

Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S.

PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.

(c) Assuming that the Options (call option) exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation

(d) What is the best alternative?

Answer 1

Solution:

Part C )

We have to evaluate the call option and these are the information given- call option premium = 0.014 Cent / Yen and Strike price = $ 0.0081 / Yen.

Total cost of option purchase = Option premium per yen * Total amount of Yen = .014/100 * 500,000,000 = $70,000

This cost will be incurred today hence the future value of the cost = 70,000 * ( 1+8%) = $75,600

We have strike price of $0.0081 / Yen and we can exercise the option when spot price at the time of expiry is higher than the strike price.

Spot price at the time of expiry = 100 Yen / $ = 1/110 Yen / $ = $0.0091 / Yen

Now this spot rate > the strike price hence option will be exercised

We will buy ¥500,000,000 by buying at the $0.0081 / Yen

Dollar value of the transaction =  ¥500,000,000 * $0.0081/ ¥ = $4,050,000

Total cost = Premium paid + $4,050,000 = $4,125,600

Part D )

Cost of forward contract = ¥500,000,000 / ¥110 / $ = $4,545,455

Cost by selecting option = $4,125,600

Hence option alternative is better than the forward contract.