Question

International Investment & Finance AIF5931
Assignment #01
Due date: 1 May 2020
(a). Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $0.60. The one-year forward rate of the Singapore dollar is $0.62. Carbondale created a probability distribution for the future spot rate in one year as follows:
Future Spot Rate    Probability
$0.61 20%
$0.63 50%
$0.67 30%
Assume that one-year put options on Singapore dollars are available, with an exercise price of $0.63 and a premium of $0.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $0.60 and a premium of $0.03 per unit. Assume the following money market rates:
U.S    Singapore
Deposit rate 8%    5%
Borrowing rate 9%    6%

Given this information, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position. What is the probability that the option hedge will cost more than the forward hedge? What is the probability that the option hedge will cost more than an unhedged strategy?

(b). Assume that Baton Rouge, Inc., expects to need S$1 million in one year. Using any relevant information in part (a) of this question, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position. What is the probability that the option hedge will cost more than the forward hedge? What is the probability that the option hedge will cost more than an unhedged strategy? (25 marks

Answer 1

Forward hedge would fix the Singapore Dollar price at 1S$ = $0.62

If options hedge is used, one has to use put options with strike $0.63 at a premium of $0.04. This would fix the minimum exchange rate at $0.63

The probability of achieving payoff of $0.63 is = probability when future spot price < or equal to $0.63

=0.2+0.5 = 0.7 or 70%

There is a 30% probability that options will not be exercised.

This happens when future spot price = $0.67 and the payoff is $0.67

So, expected payoff using options = (70%*$0.63+ 30%*$0.67) - $0.04 = $0.602 (which is the rate realised using options)

So, forward hedge is better than Options hedge in this case

For Money market hedge , one borrows the present value of Receivable i.e. S$500000 at 6% = 500000/1.06 = S$471698.11 , converts the money from Singapore Dollar to US Dollars at the spot rate to get $471698.11*0.6 =$283018.87 and invest the money in US at 8% to get $305660.38 after one year. The Receivables are used to pay the Loan in Singapore Dollars

So, effective exchange rate locked = $305660.38/S$500000 = $0.6113 with money market hedge

So, the Best exchange rate is realised with Forward Hedge

If left unhedged, the Expected rate realised = $0.61*20%$0.63*50%+$0.67*30% = $0.638 as compared to $0.62 in Forward hedge

So, It is better to leave the exposure unhedged

Options hedge prove better only in the case when future spot price = $0.67 with probability of 30%

as the realised price= $0.67-0.04 = $0.63 in this case which is more than the forward hedge rate,

So , the probability of options hedge proving costlier than forward hedge= 70%

Options hedge are not better in any situation as there is 0% chance that the future spot price is less than( Strike - premium = $0.63-$0.04) = $0.59

So , the probability of options hedge proving costlier than unhedged strategy = 100%