Question

1. Home Co, a US company making small kitchen appliances, imports plastics from Mexico. Home Co makes an order for next year for plastics, for which it will have to make a payment of MXN150 mn in 1 year. Casa’s finance manager is worried about Mexican Pesos (MXP) because it can be very volatile due to problems in the economy, so he decides to hedge the payable.

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)

1. By using the relevant information above, calculate the cost of hedging for each of the 3 methods (forward hedge, money market hedge or option hedge) to Casa Co. Which one should the company use, why? (15 points)
2. Would Casa be better off if it did not make the hedge? (5 points)

Answer 1

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.