Question

Apple, an American company, sold a mobile phone chip to a Singaporean company, for which Apple billed S$ 220 million. The invoice is payable in 6 months. The current information is available in the foreign exchange market: Apple sell

	$/S$
Spot	0.8645
6-month forward	0.8656
6-month call option strike price	0.8662
6-month call option premium ($ per S$)	0.01
6-month put option strike price	0.866
6-month put option premium ($ per S$)	0.015

(a)    If the expected spot exchange rate in 6 months is 0.8731 $/S$. What is the expected gain/loss from the forward hedging? If you were the financial manager of Apple, would you recommend hedging this foreign exchange exposure? Why or why not? [2.5 MARKS]

(b)    Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not? [2.5 MARKS]

(c)     Suppose you would like to hedge using options. Explain which option position you would enter. [2 MARKS]

(d)    The current interest rate in the US is 5% p.a. What is the $ proceeds of this option hedge if the future spot rate is $0.8700/S$? [3 MARKS]

Answer 1

(a)  Expected gain/loss from the forward hedging:

Forward rate = $0.8656/S$

Make a forward contract to sell S$220 million

Amount to be received after the period of 6 months =$0.8656*220 million

=$190.432

Without using forward hedging option:

Amount to be received after the period of 6 months =$0.8731*220 million

=$192.082

Expected loss =192.082-190.432= $1.65 million

The option of forward hedging will not be recommended as it will results in loss.

(b) Hedging have to be done in the case where the predicted future spot rate is same as current forward rate, as it will make the future receipt with certainty. With the use of spot rate it will tend to have some level of uncertainty.

(c) Option hedging:

If the rate of currency falls there may be a loss. So it is advisable to use put option for hedging the loss where the gain in put option will tend to offset the loss in spot.

(d) $ proceeds of this option hedge if the future spot rate is $0.8700/S$:

Cost of put option =$0.015*220 million=$3.3 million

Future value of the amount of $3.3 million after six months at the rate of 5% per annum

=3.3*(1+(0.05/2))=$3.3825 million

Amount to be received after 6 months=$0.8700*220million=$191.40 million

Net amount received =$191.40-$3.3825= $188.0175 million