Question

PLEASE SHOW WORK

Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.

(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.

(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?

PLEASE SHOW WORK

Answer 1

Answer a)

Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.

In the case of forward hedge, the $ cost will be

500,000,000/110 yeb per dollar = $4,545,455

In case of monety market hedge, the future dollar cost will be :

500,000,000(1.08)/(1.05)(124)=$4,147,465

Answer b)

Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.

option premium

500,000,000*0.014%

=$70,000

Future value will be

$70,000*1.08

=$75,600

Expected future spot rate

$0.0091

(=1/110)

Higher than the exercise of $0.0081, PCC will exercise its call option

and buy

¥ 500,000,000.00

for $4,050,000 ($500,000,000 *.0081)

Exptected cost will thus be $4,124,600, which is the sum of $ 75,600 and $4,050,000

Answer c)

At what future spot rate do you think PCC may be indifferent between the option and forward hedge?

When the option hedge is used, PCC will spend at $4,125,000. On the other, when the forwar hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. means that the option hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and option hedges