Question

Costa Cruise Lines (CCL) (a U.S. company based in Miami, FL) purchased a ship from Komatsu Heavy Equipment for ¥700 million – payable in 1 year.  The current spot rate is ¥110/$ and the one-year forward rate is ¥108/$.  

For borrowing (or depositing), the annual interest rate in Japan is 6%.  In the United States, the rate is 2%.

Yen call and put options, with a 1-year expiration date and an exercise price of $.009 are available. The price (premium) of the call option is $.002 per yen.  The price (premium) of the put option is $.001 per yen.

* Assume that one year from today, the spot rate for yen is either ¥130/$ or ¥105/$.  If CCL decides to hedge with options, should they use a call or a put?  If CCL follows the appropriate options hedging strategy, what is CCL’s net cost (in $US) to purchase the ship if the spot rate is ¥130/$?  What is the net cost if the spot rate is ¥105/$?  (Be sure to include the cost of buying the option in your answer.)

Recommended strategy (check one box):  Call options….□                   Put options….□

Net Cost if ¥130/$ = $____________________    Net cost if ¥105/$  = $____________________

* If CCL decides to hedge with a forward contract, what will the ship cost (in $US)?

* If CCL decides to use a money market hedge, what will the ship cost (in $US)?

Answer 1

* Assume that one year from today, the spot rate for yen is either ¥130/$ or ¥105/$.  If CCL decides to hedge with options, should they use a call or a put?  

The CCL need to pay in yen after one year. So they need to buy the Yen after one year. So they are going to take Call Option which gives CCL the right to buy Yen

If CCL follows the appropriate options hedging strategy, what is CCL’s net cost (in $US) to purchase the ship if the spot rate is ¥130/$?  

Exchange Rate of Exercise price in Yen/Dollar = 1 / Exercise Price = 1 /0.009 = Yen 111.11 / Dollar

as the Exercise price is less than Spot rate, the call option will be exercised

Net Cost = Exercise Price * Yen payable + Premium Paid

Net Cost = $0.009 * 700000000 + $0.002 * 700000000

Net Cost when Spot Rate is Yen 130/$= $7700000

What is the net cost if the spot rate is ¥105/$?  (Be sure to include the cost of buying the option in your answer.)

Exchange Rate of Exercise price in Yen/Dollar = 1 / Exercise Price = 1 /0.009 = Yen 111.11 / Dollar

as the Exercise price is more than Spot rate, the call option will be lapsed and the yen purchased at market price

Net Cost = Spot Price * Yen payable + Premium Paid

Net Cost = 1/105 * 700000000 + $0.002 * 700000000

Net Cost when Spot Rate is Yen 105/$= $8066666.67

* If CCL decides to hedge with a forward contract, what will the ship cost (in $US)?

Ship Cost with Forward Contract = Amount Payable * Forward Rate = 700000000 * 1/108 = $6481481.48

* If CCL decides to use a money market hedge, what will the ship cost (in $US)?

Ship Cost with Money Market Hedge = Present Value of Yen at Japan Interest Rate * Exchange Rate * (1 + US Interest Rate)

Ship Cost with Money Market Hedge = [700 Million/(1+0.06)] * 1/110 * (1 + 0.02)

Ship Cost with Money Market Hedge = [660377358.49] * 1/110 * 1.02

Ship Cost with Money Market Hedge = [6003430.53 * 1.02

Ship Cost with Money Market Hedge = $6123499.14

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