Question

1. Singapore Airlines just signed a contract to purchase an Airbus A380 aircraft to increase its ability to operate services on long haul major routes. Singapore Airlines will be billed €500 million which is payable in one year. The current spot rate is SGD1.58 per euro and the one-year forward rate is SGD1.62 per euro. The annual interest rate is 3.5% in the euro zone and 5% in Singapore. Singapore Airlines can also buy a one-year call option on euro at the strike price of €0.601 per SGD for a premium of 0.14 cents per euro. The expected spot rate in one year is SGD1.63 per euro.

1. Discuss whether Singapore Airlines should use a long or short forward contract to hedge currency risk, or should consider the money market hedge. Compute the future SGD costs of meeting the Company’s obligation using the money market hedge and the forward hedges (show workings).                                                                                [2+2 marks]

2. Do you think that Singapore Airlines should also consider the option hedge and why? What is the expected future SGD cost of meeting the Company’s obligation when the option hedge is used?                    [2+2 marks]

3. When the expected spot rate in one year is SGD1.63 per euro, do you think Singapore Airlines may be indifferent between the option and forward hedge? Explain.                                                                      [1+3 marks]

Answer 1

a) As Singapore Airlines will require to pay €500 milion after one year , to hedge, they have to purchase or long forward contract on Euro. If they do so, they will be able to fix a price of SGD1.62/€ and the total SGD amount required will be €500 million* 1.62 = SGD 810 million

In money market hedge, Singapore Airlines will borrow an amount in SGD, convert the same to Euro and invest the amount in Euro today so that the maturity amount is €500 million after one year

Amount required today =   €500 million /1.035 = €483.09179 million

Equivalent amount in SGD required to be borrowed today = €483.09179 million*1.58 = SGD 763.285 million  

Maturity amount of SGD borrowings = 763.285*1.05 = SGD 801.44928 million

So, effective exchange rate = 801.44928/500 = SGD 1.6029/€

So, Singapore Airlines should go for Money Market Hedge (as the total amount in SGD paid is lesser)

b) In options hedge, the strike price = €0.601 per SGD or SGD1.6639/€

and premium = 0.14 cents/€ or SGD 0.0014/€

So, maximum amount payable = SGD1.6639/€ + SGD 0.0014/€ = SGD 1.6653/€

Options hedge is used when the company wants to limit the downside risk but wants to profit from the upside potential gain. The particular option hedge is not very useful as the maximum price is too high and the option may not be exercised. Also, the expected spot rate in one year is SGD1.63 per euro. In this case, Singapore Airlines will lose the premium amount of 500 million * 0.0014 = SGD 0.7 million and the maximum amount the required to be paid by the company will be SGD1.6639/€ or a total of SGD831.95 million. The money market hedge is much cheaper than the above.

So, by options hedge, Singapore Airlines can fix the maximum payable in SGD to 831.95+0.7 = SGD832.6468 million and it is clear that Money market hedge is better in this case as the expected spot rate is SGD1.63 per euro. at which price the company will have to pay SGD1.63/Euro *500 = SGD 815 million as well lose the SGD0.7 million premium paid.

So, Singapore Airlines should not consider the options hedge.

c) If expected spot rate in one year is SGD1.63 per euro, the forward hedge is better as it locks the exchange rate at SGD1.62/€ . Total amount paid = 1.62*500 = SGD810 million

whereas in options hedge, the option will not be exercised and total amount payable is SGD1.63/Euro *500 = SGD 815 million as well the SGD0.7 million premium paid. = SGD 815.7 million

So, forward hedge is better ( Singapore Airlines will not be indifferent between the option and forward hedge)