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

a. Forward Contract

Money Market Hedge

Options and FX Advisor's Forecast

b. Based on the information above, it can be seen that Money Market Hedge is the better choice among the four options. Forward contracts are legally bound and CVT will incur higher payment compared to Money Market Hedge. Options will give the company the opportunity to take advantage of any favourable exchange rate movements at the cost of premium. Relying in FX advisor's forecast is risky.