Question

International Economics class problem:

What do the hedging alternatives look like given the following information for a 90-day, 1,000,000 account payable?

Spot rate: 0.9 to 1 domestic to foreign

90-day forward rate: 0.85 to 1 domestic to foreign

Money market periodic: 0.1%

OTC Option with strike price of 0.85 to 1 at a cost of 0.5%

Answer 1

SOLUTION;-

GIVEN DATA ;

Spot rate: 0.9 to 1 domestic to foreign

90-day forward rate: 0.85 to 1 domestic to foreign

Money market periodic: 0.1%

OTC Option with strike price of 0.85 to 1 at a cost of 0.5%

Let us break down the scenarios in simple terms. Let the foreign currency be denoted by F and the domestic currency be denoted by D.
We have 1,000,000 account receivable in foreign currency. As per the spot rate of 1.4F= 1D, the account receivable in domestic currency = 1,000,000/1.4= 714,285.71 D

Money market periodic=	0.10%
Spot rate (F/D)=	1.4
Spot rate (D/F)=	0.714286	=1/1.4
Periodic is usually given in domestic currency terms.
90 days forward rate (D/F)=	S0* e^(rt)
	0.714357	=0.714286*EXP((0.0001))
90 days forward rate (F/D)=	1.39986	=1/0.714357

Hedging alternative 1- buy OTC option (sell F after 90 days for 1.35F=1D) -

Cost = 0.50%

Cost (F)= 5000 =1000000*0.5%

Since this cost is to be paid at the initiation of the contract i.e. today, we can use the current spot rate to calculate the equivalent D

Cost (D)=

3571

=5000/1.4

At expiry, expected spot price (90 days forward as calculated above) is 1.39986 F= 1D. The option will be in the money and will be exercised.

Payoff from exercising option=	740741	=1000000/1.35
Payoff from then spot rate=	714357	=1000000/1.39986
Profit from hedging	22812	=(740,741-714,357)-3571

Hence, The hedging strategy of purchasing options is profitable.

Hedging alternative 2- buy forward rate contract (lock forward price of 1.3F= 1D)-

Forward contract rate	1.3
90 days forward estimated rate=	1.39986
Payoff from exercising option=	769231	=1000000/1.3
Payoff from then spot rate=	714357	=1000000/1.39986
Profit from hedging	54874	=769,231-714,357

Hence, the hedging strategy of purchasing forward rate is profitable.