Question

Narto Co. (a U.S. firm) exports to Switzerland and expects to receive 200,000 Swiss francs in one year. The one-year U.S. interest rate is 5% when investing funds and 7% when borrowing funds. The one-year Swiss interest rate is 9% when investing funds, and 10% when borrowing funds. The spot rate of the Swiss franc is $.80. Narto expects that the spot rate of the Swiss franc will be $.75 in one year. There is a put option available on Swiss francs with an exercise price of $.79 and a premium of $.02.

a. Determine the amount of dollars that Narto Co. will receive at the end of one year if it implements a money market hedge.

b. Determine the amount of dollars that Narto Co. expects to receive at the end of one year (after accounting for the option premium) if it implements a put option hedge.

Answer 1

Answer to Question a,

Borrowing present value of 200,000 Swiss francs,and convert to US $ using spot rate now and invest for 1 year at investment rate in US$,

Present value = Cash flow / (1+i for the period) ⁿ , i = interest rate in Swiss francs for borrowal = 10%,

So the borrowal will be 200,000 Swiss francs / 1.1 = 181818.181818182 Swiss francs,

and Convert to US$ = 181818.181818182 X 0.8 = $145454.5454545,

and invest these $145454.5454545 for 1 year at US $ investment rate = 5%,

here use formula for compounding, = cash flow X (1+i), here i = 5%,

So the maturity value = $145454.5454545, X 1.05 = 152727.272727272,

Answer to Question b,

If it goes with put option hedge, It will receive $0.79 per Swiss francs,

So total amount will be 200,000 X 0.79 =$158,000.

Total Put option premium paid at inception of option = $0.02 X 200,000 swiss francs,

= $4,000. it is to be compounded for the period of exercising the option. it is assumed that the company doesnot have money in hand for option premium, so it borroed at 7%,

= $4,000 X 1.07 = $4,280,

Net inflow = $158,000 -$4,280 = $153,720

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