Question

Indiana Company expects to receive 1 million euros in one year from exports. It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar cash flows received as a result of using the following strategies:

a) unhedged strategy

b) money market hedge

c) option hedge

The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Company

uses the forward rate as a predictor of the future spot rate. The annual interest rate in the U.S. is 8% versus an annual interest rate of 5% in the eurozone. Put options on euros are available with an exercise price of $1.11, an expiration date of one year from today, and a premium of $.06 per unit. Estimate the dollar cash flows it will receive as a result of using each strategy. Which hedge is optimal?

Answer 1

The Cash flows from the mentioned three strategies will be as below:

a) Unhedged Strategy - This is a the most riskiest startegy as here is no downside as well as upside cover to take care. Here the 1 million Euro receivable will be sold at the spot rate after 1 year, so the actual dollar cash flow will be known after 1 year. However we may assume that spot rate after 1 year is strike price of put i.e $1.11, so he will sell at $1.11.

So, Cash Flow after 1 year = 1000000 * 1.11 = $1,110,000

So, Net Gain on Unhedged Strategy = 1110000- 1000000

= $ 110,000

b) money market hedge - As foreign currency is receivable after 1 year, we need to follow steps:

1. Borrow the foreign currency in an amount equivalent to the present value of the receivable
2. Convert the foreign currency into domestic currency at the spot exchange rate.
3. Place the domestic currency on deposit at the prevailing interest rate.
4. When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

As per the above steps :

PV of 1 Million Euro @ 5% = 1000000/1.05

= 952,380.95  

Spot Rate = $ 1.1

Value in $ = 952380.95 * 1.1 = 1,047,619.05

$ Deposited @ 8% , and value after 1 year = 1047619.05 * 1.08 = 1,131,428.57

Payment to be made after 1 year including interest = $ 1000000

So, Net Gain on Money Market Hedge = 1131428.57 - 1000000

= $131,428.57

c) option hedge - In option hedge Indiana has to buy a put option for 1 year which is being sold with exercise price of $1.11 and premium of $0.06

So, With this put option, Indiana will have the option of selling the 1 million euros after 1 year at $ 1.11, but without any obligation.

Assuming he will exercise the option so, the cash flow will be at the rate of ($1.11 - $0.06) = $1.05

So, Dollar Inflow after 1 year = $ 1,000,000*1.05 = $ 1,050,000

Net Gain on Option Hedge = 1050000- 1000000 = $ 50,000

Thus, As per the above calculations, option 2 i.e money market hedge is more beneficial for Indiana with a total gain of $ 131428.57