Question

A U.S. exporter has a €1,000,000 receivable due in one year. Suppose the current spot exchange rate S($/€) = $1.2/€, the one-year forward exchange rate F360($/€) = $1.25/€, the annual U.S. interest rate i$ = 5%, and the annual euro zone interest rate i€ = 4%.

a. How to implement a hedge using a forward contract? Compute the guaranteed dollar proceeds in one year using the forward hedge.

b. How to implement a money market hedge? Compute the guaranteed dollar proceeds in one year using money market hedge.

c. If the U.S exporter decides to hedge using put option on euros, what would be the dollar proceeds in one year? Assume that the spot exchange rate S($/€) = $1.25/€ in one year. Also suppose that a one-year put option on euros has an exercise price of $1.23/€ and a premium of $0.02/€.

Answer 1

a) US exporter has Euro recievable in one year, to be sure of gaurentee dollar proceeds after one year exporter has to sell one year Euro forward.

Cash flow in US Dollar after one year = 1000000 * 1.25 = US$ 1,250,000

b) For Implementing a money market hedge we will have to follow the following steps

Step 1 - Borrow the present value of Euro recievable in 1 year from now

Step 2- Convert Euro in dollar using spot exchange rate

Step 3 - Invest Dollar at the prevailing interest rate

Step 4 - After one year repay the Euro loan using proceeds from exprt recievable

Step 1 - Calculation on Euro to be borrowed

= 1000000 / 1.04 = Euro 961,538.46

Step 2 - Convert Euro into $ using spot exchange rate

= 961,538.46 X 1.2 = US $ 1,153,846.15

Step 3 - Invest $ at prevailing rate

= 1,153,846.15 X 1.05 = 1,211,538.46

Therefore gauranteed cash flow after 1 year in $ is 1,211,538.46

3) Since the put option is out of the money there will be no proceeds from the put option

Exporter will simply convert the Euro in Dollar

Proceeds = 1,000,000 X 1.25 = US $ 1,250,000