Question

Airbus sold an A400 aircraft to Delta Airlines, a U.S. company, and billed $30 million pay- able in six months. Airbus is concerned about the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/€ and the six-month forward exchange rate is $1.10/€. Airbus can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six- month interest rate is 2.5 percent in the euro zone and 3.0 percent in the United States.

a. Should a firm hedge? Why or why not?

b. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forward contract.

c. If Airbus decides to hedge using money market instruments, what action does Airbus need to take? What would be the guaranteed euro proceeds from the American sale in this case?

d. If Airbus decides to hedge using put options on U.S. dollars, what would be the “expected” euro proceeds from the American sale? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

e. At what future spot exchange do you think Airbus will be indifferent between the option and money market hedge?

Answer 1

Answer a)

The firm should hedge.

Hedging is a tool to minimize or eliminate currency risk in this question.

There are receivables in $ whereby the functional (needed) currency is Euro.

Hence, there is an exposure or risk of fall in Euro.

In order to eliminate this risk, hedging should be done.

Currently the spot rate is $1.5/€ or €0.667/$ (1/1.5) implying 1 $ = €0.667

In the future, Euro might fall and we might Airbus might receive a lesser amount. Hence, hedging is required.

Answer b)- If Airbus hedges through forwards,

the forward rate is $1.1/€

i.e. €1 = $1.1

= $30 million

= $30 mn * €1/$1.1 = €27.27 million

Answer c) -

6-month interest rate			2.5% - Eurozone	3% - US
6-month interest rate factor			1 + 2.5%/2	1 + 3%/2
			1.0125	1.015
T=0			T=6 months
T=0		inflow/(outflow)			inflow/(outflow)
Borrow present value of future receipt $	$30 mn/1.015	$29.5566 mn	Pay amount borrowed at 3%	$29.5566 mn*1.015	($30 mn)
Invest in € equivalent at spot	$29.5566 mn/$1.5	€ 19.7044 mn	Received amount invested at 2.5%	€ 19.7044 mn*1.0125	€ 19.9507 mn
			Receive from sale of		$30 mn
			Net Receipt		€ 19.9507 mn

Answer d)

Since the exercise price is €0.95/$

This implies if the actual $ rate is lower than the exercise price, the put will be exercised.

The question says the forward rate to be unbiased predictor of future spot rate.

Hence, the future spot rate = $1.1/€ or   €0.909/$ (1/1.1)

Clearly, the future spot rate is lower than the exercise price, hence put shall be exercised.

The exchange rate will now be the exercise price i.e. €0.95/$

1 $ = €0.95

30 mn $ = 30 mn*0.95 = €28.5 mn

• We have not taken into account put premium which is €0.02/$ i.e. €0.6 mn paid at T=0 whose future value will be €0.6 mn*1.0125 = €0.608 mn
• After taking this into account, the net proceeds in Euro will be (€28.5 mn  -  €0.608 mn) =  €27.893 mn

Answer e)

The answer is $1.05/€