Question

Assume that Pomo Limited, a US based firm, expects to receive S$800,000 in one year. The existing spot rate of the Singapore dollar is US$0.74. The one-year forward rate of the Singapore dollar is US$0.76. Pomo created a probability distribution for the future spot rate in one year as follows:

Future Spot | Rate Probability

US$0.75 | 20%

US$0.77 | 50%

US$0.81 | 30%

Assume that one-year put options on Singapore dollars are available, with an exercise price of US$0.77 and a premium of US$0.04 per unit. One-year call options on Singapore dollars are available with an exercise price of US$0.74 and a premium of U$0.03 per unit. Assume the following money market rates:

U.S. | Singapore

Deposit rate: 9% | 6%

Borrowing rate: 10% | 7%

Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Pomo Limited should hedge its receivables position.

a. Calculate the forward contract hedge.

b. Calculate the money market hedge.

c. Calculate the option hedge.

d. Briefly discuss the optimal hedge against the no hedge position of the company.

e. Discuss whether the multi-national corporation (MNC) like Pomo Limited will risk be over-hedged its position to the extent affect the company's financial position.

Answer 1

a)	Amount receivable under the forward hedge = 800000*0.76 =	$   608,000
b)	As the FC exposure is an asset in S$, a liability should be created in S$ which will have a value of S$100000 in 1 year.
	For this an amount should be borrowed in S$ such that it becomes S$800000 in 1 year, together with interest.
	Amount to be borrowed = 800000/1.07 =	747664	S$
	This amount of 747664 S$ should be converted at the spot rate and invested in $.
	Amount received on conversion and deposited = 747664*0.74 =	$   553,271
	Maturity value of the deposit = 553271*1.09 =	$   603,066
	ON THE DUE DATE, THAT IS 1 YEAR LATER
	*the FC receivable of S$800000 will be collected and used for the repayment of the borrowings, which together with interest would have become S$800000.
	*the $ deposit will be realized which, together with interest at 9% would have become $606066.
	Therefore, amount receivable under the MMH =	$   603,066
c)	To hedge, a put option should be bought.
	Amount receivable if, the put option is exercised = 800000*0.77 =	$   616,000
	Less: Premium payable together with interest at 10% = 800000*0.04*10% =	$        3,200
	Value of the net receipt under put option in FV terms	$   612,800
d)	Expected spot rate = 0.75*0.20+0.77*0.50+0.81*0.30 =	0.778
	Total amount receivable at the expected spot rate = 800000*0.778 =	$   622,400
	The amount receivable under the hedge alternatives:
	Forward contract	$   608,000
	Money market hedge	$   603,066
	Put option	$   612,800
	The optimal hedge is he put option which promises at least $612,800.
	However, this is less than the amount receivable at the expected spot rate.
	But the company can choose the put option as it ensures a minimum of $612800. In the event the expected spot rate holds good the put option will not be exercised and the company will get a net of 800000*0.778-3200 =	$   619,200
e)	No. Over exposure can create financial losses if the spot rate after 1 year goes down.