Question

Vericity Corporation, located in the United States, has an accounts receivable of SF400 million due in one year from a firm in Switzerland. The current spot rate is SF1.67/$ and the one year forward rate is SF1.58/$. The annual interest rate is 3.0% in Switzerland and 4.0% percent in the United States. Vericity can also buy a one-year put option on the Swiss franc at the strike price of $.6440 per Swiss franc for a premium of $0.005 per Swiss Franc.

a. Compute the guaranteed dollar proceeds at the time of payment if Vericity decides to hedge using a forward contract. Show your calculations.

b. Compute the guaranteed dollar proceeds at the time of payment if Vericity decides to hedge using a money market hedge. Show your calculations.

c. List the steps that Vericity needs to take in order to use a money market hedge to eliminate its transaction exposure. Be sure to include the time (t=0 or t=1 year) at which each step must be taken.

d. Suppose that Vericity decides to hedge using an option contract. Assume that the forward rate is the best predictor of the future spot rate. Is Vericity likely to exercise its option contract? Explain using the rates provided. (1 point)

e. Compute the expected dollar proceeds at the time of payment if Vericity decides to hedge using an option contract. Show your calculations. (3 points)

Answer 1

	a	HEDGE USING A FORWARD CONTRACT
		One Year Forward Rate:SF1.58/$
		Guarranteed dollar proceeds=400million/1.58=	$253,164,557
	b	Borrow (400million/1.03) SF in Switzerland	388,349,515	SF
		Convert intoUSD at Spot rate SF1.67/$	$232,544,619	(388349515/1.67)
		Invest in US at 4%
		Amount at the end of one year	$241,846,404	(232544619*1.04)
		Guarranteed dollar proceeds	$241,846,404
	c	STEPS FOR MONEY MARKET HEDGE
		Step1:at t=0 Borrow 388349515 SF inswitzerland at 3%
		Step2:at t=0 Convert at spot rate and get	$232,544,619
		Step3:at t=0 Invest the proceeds in US at 4% for one year
		Step4:at t=1 Receive 4 million SF and pay back loan with interest	400,000,000	SF	(388349515*91.03)
		Step5: at t=1 Receive $241846404 after one year on maturity	$241,846,404	232544619*1.04)
	d	Strike Price	$0.6440
		Spot rate after one year=forward rate=1/1.58=	$0.6329
		Payoff on put option=(0.6440-0.6329)=	$0.0111
		Premium	($0.005)
		Net profit per SF	$0.0061
		Yes,Veracity is likely to exercise Option.
		Veracity will make profit
	e	Expected Dollar proceeds from option =0.0061*4 million	$24,354