Question

Suppose you are working at Air Italy, a commercial airline company in the European Union, and you recently purchased an order of 5 new planes of the Boeing 737 Max 8 for a total of $622 million from Boeing, a United States airplane manufacturer. Due to the news of two recent accidents likely linked to the software on these planes, Air Italy no longer wants to risk using them. Thus, Air Italy decides to return the order to Boeing for the full price. In order to receive all the funds, you must return this plane in 3 months (the remaining length of the warrantee), at which time Boeing will then pay you. However, you will have to convert this entire dollar payment into Euros in order to cover wages, routine maintenance costs, and administrative costs. You anticipate the dollar will depreciate relative to the euro and consider hedging the foreign exchange risk by using a forward contract to sell dollars for Euros. Today’s spot and 3-month forward exchange rates are given below.

Spot Price: $1 = € 0.901 3-Month Forward Price: $1 = € 0.889

a) Assuming that there are no transactions costs, how many Euros will Air Italy receive in three months if it enters into the forward contract?

b) If Air Italy does not hedge its risk and the exchange rate remains constant, how many Euros will it receive in three months?

c) Now, suppose that the dollar does in fact depreciate and that its spot price three months from today equals €0.876. If Air Italy does not hedge, how much revenue does the company lose from the exchange rate fluctuation (compared to what they would have made without hedging if the exchange rate had remained constant)?

d) Assuming the spot rate equals €0.876 three months from today, would entering into the forward contract have been a good idea in this case? Explain your answer.

e) If after three months the dollar has appreciated by exactly 5.0% and Air Italy has a hedged position, what is the value of its forgone revenue (i.e. what are the company's lost profits)?

Answer 1

a). Italy will receive $622 in three month. 3 month forward contract is $1 = € 0.889. hence Italy will receive 622 multiplied by 0.889 = 552.958 euros after three months if it inters into forward contract.

b). If Italy does not hedge its risk and exchange remains constant at $1 = € 0.901, then it will receive 622 multiplied by 0.901 = 560.422 Euros after three months.

c). If dollar depreciates to $1 = € 0.876, then euros received without hedging = 622 multiplied by 0.876 = 544.872

If dollar had not depreciated, without hedging Italy would have received 560.422 Euros.

So Italy makes a loss of (560.422 – 544.872) = 15.55 euros due to dollar depreciation.

d) if spot rate equals $1 = € 0.876, then euros received without hedging = 622 multiplied by 0.876 = 544.872

dollars received with hedging = 622 multiplied by 0.889 = 552.958 Euros. Hence entering in forward contract would have given (552.958-544.872) = 8.086 Euros more. Forward contract would have benefitted Italy

e) Spot rate is $1 = € 0.901. Let $1 = € x be the exchange rate after three months. Since dollar has appreciated by 5%.

(x – 0.901)/0.901 = 0.05

Hence x- 0.901 = 0.04505

x = 0.901 +0.04505 = 0.94605

Therefore after three months exchange rate is $1 = € 0.94605

At the above exchange rate Italy would have received 622 multiplied by 0.94605 = 588.4431 Euros

With hedging Italy receives 552.958 Euros which is less than without hedging.

Lost profits due to hedging = 588.4431 Euros - 552.958 Euros = 35.4851 Euros lost