Cap Inc., a U.S. manufacturer, purchased computers from a German seller for €4,000,000, payment to be...

Cap Inc., a U.S. manufacturer, purchased computers from a German seller for €4,000,000, payment to be made in 1 year. . The spot rate and the one year forward rates between the dollar and the Euro are $1.2403/€ and $1.2456/€ respectively. One-year put options on the Euro are available with an exercise price of $1.30/€ and a premium of $0.05/€. One-year call options on the Euro are available with an exercise price of $1.30/€ and a premium of $0.07/€. Would you suggest Cap Inc.’s CFO, Mr. Steve Rogers, to hedge their exposure using a forward hedge or an option hedge? In your calculations, consider the following possible spot rates at maturity (in one year): $1.10/€, $1.20/€, $1.40/€, and $1.50/€. (Which hedge would they pick at each possible future rate?) Note: Failure to specify whether/what you are buying or selling will result in a zero score. Also, show all your calculations or you will receive no credit.

Expert Solution

Cap Inc.has to make a payment in € in year. So, Cap Inc. has buy € by paying $ in 1 year. Therefore, Cap Inc. has to hedge against a rise in the $/€ exchange rate.

As Cap Inc. has to hedge against a rise in the $/€ exchange rate, it needs to sell the forward contact on the €, or buy a call option on the €.

Forward hedge

With the forward hedge, amount paid after 1 year = number of € * 1-year forward rate

Option hedge

If the spot rate after 1 year is lower than the option strike price, the call option will not be exercised. Effective rate paid per € = (spot rate after 1 year + premium paid on call option).

If the spot rate after 1 year is higher than the option strike price, the call option will be exercised. Effective rate paid per € = (option strike price + premium paid on call option).

Amount paid after 1 year = number of € * Effective rate paid per €

At each of the spot rates at maturity, the amount paid in $ is calculated as below :

The hedge which as a lower total $ payment will be chosen.

If the spot rate in 1 year is $1.10, the option hedge will be chosen. In all the other cases, the forward hedge will be chosen

jeff jeffy answered 1 year ago

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