Question

Your firm has receivables of NZD 4 Million due in one year. The following information applies:

Current Spot Rate	US Interest Rate	New Zealand Interest Rate
.53	6.5%	11.0%

1-year Put options with a strike price of .52 are available for a premium of .02.

Suppose that IRP & IFE presently exist between the US and New Zealand.

Specify your firm’s proceeds for each of the following situations:

• A Forward Hedge
• A Put Option Hedge
• An Unhedged Position
• A Money Market Hedge

Answer 1

Forward Hedge:

Given

1 NZD = 0.53 USD

Given that Interet rate parity theory holds

Interest Rate in New Zealand = 11%

US Interest rate = 6.5%

If interest parity theorem holds, then by applying the interest rate on spot rates we can find the Forward price

1 NZD = 0.53 USD

1 NZD + 1NZD *11% = 0.53USD + 0.53USD * 6.5%

1.11 NZD = 0.56445 USD

1 NZD = 0.56445/1.11 USD

1 NZD = 0.5085

So Forward Price 1 NZD = 0.5085 USD

= 2.034 Million USD.

Put Option Hedge:

Since we have taken a long position on put option we can sell NZD at 0.52

Receivable amount = 4 Million NZD * 0.52

= 2.08 Millions USD

Premium paid = 4 Million NZD * 0.02

= 0.08 Milion USD

Net Amount Receivable under option Hedge = 2.08 Million USD - 0.08 Million USD

= 2 Million USD

* Assuming that if the Exchange rate after 1 year is less than 0.52 then Put option Excercised

If it is more than 0.52 then the put option lapse

Unhedged Position:

If we don’t hedge our position,whatever the actual price prevailing after 1 year then that exchange rate should be taken.

If NZD is depreciated then we will incurr loss being a exporter or if NZD is appreciated then the inflow is high.

Money Market Hedge:

Step 1: Since we are having a receivable NZD, So create a liability for an amount of Present value of receivable

Interest rate in New Zealand = 11%

Present value of 4 million NZD = 4 Million NZD / 1.11

= 3.6036 Million NZD

Step 2: Converting 3.6036 NZD into USD

1 NZD = 0.53 USD

NZD 4 Million = 0.53USD * 3.6036 Millions'

= 1.9099 Milion USD

Step 3: Investing 1.9099 Milion USD at 6.5% interest rate

Step 4: Investment Amount after 1 year

Amount receivable after 1 year = 1.9099 Million USD * 1.065

= 2.034 Milion USD

Step 5: Computation of loan balance after 1 year.

Loan Closing Balance = Opening Balance ( 1+i)

= 3.6036 Million ( 1.11)

=4 Million NZD

Step 6: After 1 year we will receive 4 million NZD. We will repay the loan amount with this 4 M NZD.

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