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

Payable 5 million EUROS in six months

HEDGING IN MONEY MARKET:

EUR 6-month Lending   rate is (10/2)=5%

Present Value of EUR,5,000,000=5000000/1.05= € 4,761,905

Current Spot exchange Rate for Selling US dollar and buy EUR:$1.28/€

Amount of US   dollar required to buy €   4,761,905

at current spot exchange rate=( 4,761,905

*1.28)

)USD=$6,095,238

STRATEGY:

Borrow $6,095,238 at US borrowing Rate 9%

Six months rate =9/2=4.5%

Convert into EUR 4761905 at current spot rate $1.28/EURO

Deposit the amount in GERMANY for 6 month at lending rate of 10%

After 6 months the deposit will grow to EUR 5 Million and will be paid for the purchase

The amount to be paid to US bank with interest=6095238*1.045= $6,369,524

FORWARD MARKET:

Forward rate:$1.34/€

Enter into a forward contract to buy 5 million EUROS

Amount to be paid after 6 months =1.34*5 million=$6,700,000

OPTION MARKET:

If exchange rate goes up, more US dollars need to be paid. To hedge the risk of loss due to increase in exchange rate, Call options need to be bought. Gain in call option will offset the loss in spot rate.

Number of Call options required=5000000

Strike Price : $1.32/EURO

Premium to be paid=2.5%*1.28*5000000=$160,000

Maximum Cost for this alternative:

5000000*1.32+160000=$6760000

Hedging Method	Maximum Cost
Money Market	$6,369,524
Forward Market	$6,700,000
Option Market	$6,760,000

MONEY MARKET HEDGING SHOULD BE ADOPTED

Other Factors:

1.Cost for no hedging if spot rate is as predicted=$1.29*5000000=$6,450,000

2. The movement of exchange rate in six months