In: Finance
He talks to the banks and collects the following information on potential hedging possibilities:
1-year borrowing rate in US$= 3%
1-year deposit rate in US$=1%
1-year borrowing rate in MXN=6%
1-year deposit rate in MXN=4%
Spot rate of MXN= $0.045
1-year forward rate of USMXN=$0.05
Future spot rate of MXN (1-year later)= $0.03 with 70% probability
Future spot rate of MXN (1-year later)=$0.04 with 20% probability
Future spot rate of MXN (1-year later)=$0.05 with 10% probability
Strike price of a 1-year call option = $0.04, premium = $0.005 (per dollar)
Strike price of a 1-year put option = $0.05 , premium= $0.005 (per dollar)
Home Co, a US company imports plastics from Mexico. Therefore, have to make a payment of MXN150 Mn in 1 year. Company is Afraid of fall in dollar price.
1. Forward hedge: In forward market Hedge Home Co will lock-in Exchange rate today at 1-year forward rate of USMXN = $0.05
Therefore, $ payable = MXN150 * 0.05 = $ 7.5 Mn
2. Money Market Hedge:
Since you have a payable, Money Market Hedge Mechanism is
· First Calculate present value of the future payment (Using FC Exchange Rate)
MXN150 / (1 + 0.04) = MXN144.23
· Now Borrow in domestic Currency the amount used to buy the present value of the future payment today at spot.
MXN 144.23 * 0.045 = $6.49 Mn
· Place the MXN 144.23 as Deposit in Mexico, At End of 1-Year MXN deposit give us MXN150 and we set-off our MXN Liability.
· At End of 1-Year, you also need to setoff amount borrow in Dollars.
Therefore, you have to repay $6.49 Mn along with Interest
= $6.49 * (1 + 0.03) = $6.6847 Mn
3. Option hedge: In option hedge we buy 1-year call option at Strike price = $0.04, by paying premium = $0.005 (per dollar)
Premium Paid = MXN150 Mn * 0.045 * 0.005 = 0.03375
Total Amount Paid = MXN150 * 0.04 + 0.03375 = 6.03375
Since Payable amount is lowest in Option hedge we should choose it.
Part 2: No in such case payment amount is higher than above.