In: Finance
Belinda’s Biorhythms Inc. expects to need C$1,000,000 in one year to pay various suppliers. Assume the existing spot rate of the Canadian dollar is US$0.70 and one-year forward rate of the Canadian dollar is US$0.72. Furthermore, the probability distribution for the future spot rate of the Canadian dollar in one year that you have gathered is as follows:
Future Spot Rate: | Probability: |
USD$0.67 | 10% |
$ 0.71 | 20% |
$ 0.73 | 40% |
$ 0.77 | 30% |
You have researched options and found one-year put options on Canadian dollars are available, with an exercise price of US$0.73 and a premium of US$0.04 per unit, and one-year call options on Canadian dollars are available with an exercise price of US$0.70 and a premium of US$0.03 per unit.
You have access to the following money market rates (and determined they are equally-risky between countries):
U.S. | Canada | |
Deposit Rate: | 3% | 2% |
Borrowing Rate | 4% | 3% |
Given all the above information, evaluate a forward hedge, money market hedge, and currency options hedge to decide which would be most appropriate. Defend your choice thoroughly. Once you have determined the optimal hedge, then consider the possibility of not hedging; what is your recommendation to Belinda and why?