In: Finance
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 /$? To be Won1,300 /$?
1. Remain uncovered, making the won payment in 6 months | ||||||
at the spot rate in effect at that date | ||||||
Account payable (won) | 6,800,000,000 | |||||
Possible spot rate in six months: current spot rate (won/$) | 1,113 | |||||
Cost of settlement in six months (US$) | 6,109,613.66 kr | Uncertain. | ||||
Account payable (won) | 6,800,000,000 | |||||
Possible spot rate in six months: forward rate (won/$) | 1,162 | |||||
Cost of settlement in six months (US$) | 5,851,979.35 kr | Uncertain. | ||||
2. Forward market hedge. Buy won forward six months | ||||||
Account payable (won) | 6,800,000,000 | |||||
Forward rate (won/$) | 1,162.00 | |||||
Cost of settlement in six months (US$) | 5,851,979.35 kr | Certain. | ||||
3. Money market hedge. Exchange dollars for won now, invest for six months. | ||||||
Account payable (won) | 6,800,000,000 | |||||
Discount factor at the won interest rate for 6 months | 1.080 | |||||
Won needed now (payable/discount factor) | 6,296,296,296.30 | |||||
Current spot rate (won/$) | 1,113.00 | |||||
US dollars needed now | 5,657,049.68 kr | |||||
Carry forward rate for six months (WACC) | 1.053 | |||||
US dollar cost, in six months, of settlement | 5,954,044.79 kr | Certain. | ||||
4. Call option hedge. (Need to buy won = call on won) | ||||||
If exercised | If not exercised | |||||
Option principal | 6,800,000,000 | |||||
Current spot rate (won/$) | 1,113.00 | 1,300.00 | ||||
Premium cost of option (%) | 4.100% | |||||
Option premium (principal/spot rate x % pm) | 250,494.16 kr | |||||
dollar cost of won (strike at 1200/$won) | 5,666,666.67 kr | 5,230,769.23 kr | ||||
Premium carried forward six months (pm x 1.05, WACC) | 263,645.103 | 263,645.10 | ||||
Total net cost of call option hedge if exercised | 5,930,311.77 kr | 5,494,414.33 kr | ||||
Maximum. | ||||||
The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be a weaker Won, Won1,200/$ or higher, then the call option would be a lower cost alternative. This would require, however, that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the Won did not fall to the needed level. | ||||||