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 Won 7,800 million. Won 1,000 million has already been paid, and the remaining Won 6,800 million is due in six months. The current spot rate is Won 1,113 /$, and the 6-month forward rate is Won1,162 /$. The 6-month Korean won interest rate is 16 % per annum, the 6-month U.S. dollar rate is 4 % 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 Won 1,200 /$ 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 10.5 %. 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 Won1,113 /$? Won1,162 /$? 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 /$? To be Won1,300 /$?

Answer 1

Part a)
Remaining Purchase Price that needs to be paid (in Billions)	6.80
Price in USD that will be paid (Spot Rate after 6 months Won 1113/$)	$          6,109,614
Price in USD that needs to be paid (Spot Rate after 6 months Won 1162/$)	$          5,851,979
Part b)
Using forward market hedge
Using Interest rate parity
1 USD * (1+0.04)= 1113 *(1+0.02) Otherwise arbitrage opportunity will be present
Also the interest rates given are per annum , divide by 2 for half yearly interest rates
Which gives us the exchange rate as $1= Won 1178.47
Calculating the amount to be paid	$          5,770,194
Part c)
Using a money market hedge
Actually whether you use forward market hedge or money market hedge
you obtain the same answer
Basically you borrow in domestic currency that is USD convert it into Won and invest it in won USD deposits
Then you earned 16% annually on won and you have to give 2% annual interest on USD you borrowed
Hence, the principal in USD borrowed is just equal to Won + Interest on won which will total to Won 6.8 billion
Hence P *(1+16/200)=6.8*10^9 or P=6.29*10^9 billion
Converting that into dollars at spot rate	$          5,656,963
Now after 6 months the paybale loan amount	$          5,713,533
Part d)
Options
Premium 4.1%
Strike Price won 1200/$	$          5,666,667
Premium Cost	$              232,333
Total Cost to be paid in USD	$    5,899,000.00
If won 1300/$ then option won't be exercised	$          5,230,769
Premium Cost	$              214,462
Total cost to be paid in USD	$          5,445,231