Question

Narto Co. (a U.S. firm) exports to Switzerland and expects to receive 500,000 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 4% when investing funds, and 6% when borrowing funds. The spot rate of the Swiss franc is $.80. Narto expects that the spot rate of the Swiss franc will be $.72 in one year. There is a put option available on Swiss francs with an exercise price of $.76 and a premium of $.03.

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

2. 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.

***Please do not use excel my professor will not except work done in excel. I need a written or step by step solution. Thank you.

Answer 1

1. Money market hedge

Narto co.has exported goods to Switzerland

As Narto is an exporter, he has to borrow swiss francs and has to invest in dollars

Amount to be received = 500,000 swiss francs after a year

Step 1 : Since maturity value of borrowing should be equal to swiss francs receivable

swiss francs to be borrowed = 500,000/(1+0.06) = 471698 swiss francs

After a year, with interest, Narto has to pay 500,000 swiss francs which company will receive from the company, whom he exported goods

Step 2 : convert 500,000 swiss francs into dollar at spot rate $0.80= 1 swiss franc

500,000 x 0.80 = $400,000

Step 3 : invest $400,000 into US @ 5%

Step 4 : collect 500,000 swiss francs from customer and repay the swiss francs loan

Step 5: After a year, receive dollar amount with interest = $400,000 (1+0.05) = $420,000

This is the guaranteed dollar proceeds under money market hedge= $420,000

2 . using put option

Narto can use put option to safeguard against any loss

The premium payable on put option (with an exercise price $0.76/ swiss francs)

     = 500,000 x $0.03 = $ 15,000

Now If the spot exchange rate is lower than $0.76, exercise the put

And if it is higher than $0.76, do not exercise option, sell in open market

So in any case, dollar receivable is :

500,000 swiss francs x 0.76 =               $ 380,000

Less : option premium

(15,000 (1+0.07) with interest     =      $ 16,050

Amount receivable in dollar        =     $ 363950

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