Question

Assume that Carbondale Co. expects to pay SGD500,000 in one year. The existing spot rate of the Singapore dollar is USD/SGD .60. The one year forward rate of the Singapore dollar is USD/SGD .62. Assume that one year put options on Singapore dollars are available, with an exercise price of USD/SGD .63 and a premium of USD/SGD .04. One year call options on Singapore dollars are available with an exercise price of USD/SGD .60 and a premium of USD/SGD .03. Assume the following money market rates and the probability distribution for the future spot rate in one year shown in the table below. 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 Carbondale should hedge its position.

Please explain your decision. U.S. Singapore Deposit rate 4% 1% Borrowing rate 5% 2% Future Spot Rate Probability USD/SGD .59 20% USD/SGD .63 50% USD/SGD .67 30%

Answer 1

In the forward hedge, the amount of USD per SGD to be paid can be fixed at the forward rate of 0.62

Since SGD is to be paid, call options on SGD have to be bought . With the available call option of strike 0.6USD/SGD and premium of 0.03USD/SGD, the maximum amount payable per SGD can be fixed at 0.63

(Put options can be sold but do not hedge the position or exposure, hence not discussed)

If money market hedge is used, the USD may be borrowed and converted to SGD today and invested so that they mature to SGD 500000 in one year

The amount of SGD required to be invested today = 500000/1.01 =SGD 495049.50

Amount required to be borrowed in USD today = 495049.50 * 0.6 = USD 297029.70

Payment in USD after one year = 297029.70 * 1.05 = USD 311881.20

So, the exchange rate fixed through money market hedge = 311881.20/500000 = 0.6237

So, a forward hedge is better as compared to money market hedge

Expected future spot rate = 0.59*20%+0.63*50%+0.67*30% = 0.634

As the expected future spot rate is 00634, if left unhedged , the exposure may be significant in USD, hence a forward hedge is better. In case the company wants to take advantage of the situation when future spot rate is 0.59 with 20% probability , the rate for the company = 0.59+0.03 = 0.62

So, there is no situation where the company can profit from the call option

The forward hedge is the best and should be undertaken