In: Finance
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 8 500 million. Won1,000 million has already been paid, and the remaining Won7,500 million is due in six months. The current spot rate is Won1,107/$, and the 6-month forward rate is Won1,178/$. The 6-month Korean won interest rate is 16?% per annum, the 6-month U.S. dollar rate is 4.5% 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 Won1,200/$ strike rate has a 3.8% premium, while the 6-month put option at the same strike rate has a 3.2?% 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 11.5?%. 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 Won1,107/$? Won1,178/$?
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?/$? to be Won1,300?/$?
e. What do you recommend?
(a) Remaining Foreign Currency Exposure = 7500 million Won
Expected 6 months spot rate = E(S1) = 1107 Won / $
Dollar Exposure at the above rate = 7500 / E(S1) = 7500 / 1107 = $ 6.7751 million
Expected 6 months spot rate = E(S2) = 1178 Won / $
Dollar exposure at the above rate = 7500 / 1178 = $ 6.3667 million
(b) 6-month forward market exchange rate = 1178 Won/$ (the exchange rate under a forwards contract)
Dollar payable under forward market hedge = 7500 / 1178 = $ 6.3667 million
(c) Lending (Investment) Rates:
Korea = RL(k) = 16 % per annum and US = RL(u) = 4.5 % per annum
Borrowing Rates:
Korea = RB(k) = 18 % and US = RB(k) =6.5 % per annum
The money market hedge would be executed as given below:
- Borrow $ 6.273212 million at the US borrowing rate of 6.5 % per annum or 3.25 % per half year.
- Convert the borrowings into Korean Won at the existing spot rate of 1107 Won/$ to yield (6,273212 x 1107) = 6944.445684 million Won
- Put the converted borrowing of 6944.445684 million Won into a Korean deposit at 16% per annum or 8 % per half year.
- The deposit value becomes (6944.445684 x 1.08) = 7500.00134 million Won or 7500 million Won approximately.
- The borrowings of $ 6,273212 million creates a loan repayment laibility of (6.273212 x 1.0325) = $ 6.4771 million after 6 months which is paid of by Bobcat Company. The effective exchange rate locked in is (7500 / 6.4771) = 1157.926 Won/$ approximately.
- The effective echange rate would be equal to the expected future rate calculated by using the principle of covered interest parity as given below:
[(1.08) / (1.0325)] x 1107 = 11 57.926 Won/$ approximately which is infact the effective exchange rate paid in the previous step.
(d) In this context the underlying asset is the foreign currency payable (Korean Won) and consequently the option would also be on the same. The company is short on the underlying asset and hence would hedge using a call option so as to guarantee a fixed exchange rate (in terms of the option's strike price) for the foreign currency payable.
Call Option Strike Price = K = 1200 Won / $ and 3.8 % premium
Option Premium = 0.038 x 1200 = 45.6 Won
If the exchange rate is below the call option's strike price of 1200 Won/$ it implies that lesser number of Wons can be purchased for a dollar in the spot market as compared to under the call option contract. Hence, in such a scenario it would be logical to exercise the call option (as it allows the purchase of a greater number of Wons for a $ as compared to the spot market). Hence, US $ payments under the call option would be (7500/1200) = $ 6.25 million
If the spot rate is below 1300 Won/$ but above 1200 Won/ $, it would make no sense to exercise the call option as a greater quantity of Won can be purchased at the spot exchange rate as compared to purchase under the call option's strike price of 1200 Won/$.The US $ payable in such a scenario would be (7500 / Existing Spot Rate in Won/$).
NOTE: Please raise a separate query for the solution to the last sub-part.