Question

Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for 5,000,000 €. The purchase is made in June today with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in € rather than $, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.

• The current spot exchange rate is $1.28/€.
• The six month forward rate is $1.34/€.
• CVT's cost of capital is 14%.
• The Euro zone borrowing rate is 12% annually.
• The Euro zone lending rate is 10% annually.
• The U.S. 6-month borrowing rate is 9% annually.
• The U.S. 6-month lending rate is 4%.
• The strike price for December call options for 5,000,000 € is $1.32/€ and the option premium is 2.5% of the total cost of the option based on the current spot exchange rate.
• CVT's FX advisor’s forecast for 6-month spot rates is $1.29/€.

Based on the information provided above:

1. Calculate the cost of each hedging alternative available to CVT.
2. Based on your findings in part (a), which hedging alternative(s) would you recommend to CVT? Which factors should CVT consider in making its final decision on choosing the best hedging alternative?

Answer 1

	SPOT RATE OF I EURO	1.28	$
	I $	0.7813	EURO
1	Forward Hedge
	Forward rate 1 EURO	1.34	$
	Purchase of Euro for six months forward	5000000	6700000	$
2	Money market hedge
	The Euro zone borrowing rate is 12% annually.
	The Euro zone lending rate is 10% annually.
	The U.S. 6-month borrowing rate is 9% annually.
	The U.S. 6-month lending rate is 4%.
	Borrow Dollar convert Euro and invest in Euro and repay dollar after 180 days
	Amount to be paid	5000000	Euro
	Amount to be invested
	Deposit ineterst of Euro six months	10%/2	5%
	Amount to be dposited	5000000/(1+.05)	4761904.76	Euro
	SPOT RATE OF I EURO	1.28	$
	Amount of borrowing in USD	Amount of depoist in Euro * spot rate
		4761904.76*1.28	6095238.093
	Interst for six months	9%*6/12	4.50%
	Interst	6095238.093*4.5%	274285.7142
	Total payment( Principal+Interest)		6369523.807	$
3	Option Hedge
	Purchase a call option
	Assuming that the option to be excersised on the day the Euro are needed
	Ecersise price Euro	1.32	$
	Premium	2.50%
		0.033	$
		1.353	$
	Expected future spot rate	1.29	$
	As the expected spot rate is 1.290$ againt 1 Euro is lower than the excercise price
	call option I Euro 1.353, the compnay will not exercise the price , if eccercise the amount is
		5000000*1.353	6765000	$
4	If remain unhedged
	Six months expected spot rate is	1.29	$
	so the amount is	5000000*1.29	6450000
5	If paid at the current rate by taking a loan
	Cost of capiatl	14%
	Six month rate	14/2	7%
	Then amount	5000000*1.28*	6400000
	Interst for six months @ 7%		448000
	Total amount		6848000	$
	CONCLUSION
	From the above different methods money market hedge is the best option.
	Please rate my answer