Question

Assume you are the CFO of a company. Your analyst reports the following information (Use the following information for the remainder of the question):

• Current exchange rate is $1.16/€.

• Forward rate is $1.175/€.

• Expected final sales volume is 35,000. Worst case scenario is volume of 15,000. Best case scenario is volume of 50,000.

• Cost per student is €2000.

• Option premium is 2% of USD strike price.

• Option strike price is $1.165/€.

1. Using the above information

a) What is the total projected costs (for all three scenarios) in dollars at the current exchange rate?

b) What are the total costs (for all three scenarios) if you use a forward contract to hedge?

c) What is the total option premium for each scenario?

2. As the CFO, you decided not to hedge. Assuming expected final sales volume is 35,000, what are your total costs

a) if the exchange rate remains at $1.16/€? Let’s call this the baseline scenario.

b) if the exchange rate will be $1.25/€? How does this compare to the baseline case?

c) if the exchange rate will be $1.11/€? How does this compare to the baseline case?

3. As the CFO, you decided to hedge using forward contracts. Assuming expected final sales volume is 35,000 and forward rate is $1.175/€. What are your total benefit/cost and the percentage benefit/cost from hedging (compared to no hedging)

a) if the exchange rate remains at $1.16/€?

b) if the exchange rate will be $1.25/€?

c) if the exchange rate will be $1.11/€?

4. As the CFO, you decided to hedge using option contracts. What type of option is suitable for this case (call option or put option)? Why?

5. As the CFO, you decided to hedge using option contracts. What are your total benefit/cost and the percentage benefit/cost from hedging (compared to no hedging)

a) if the exchange rate remains at $1.16/€?

b) if the exchange rate will be $1.25/€?

c) if the exchange rate will be $1.11/€?

6. What is the most profitable strategy for expected final sales volume is 35,000 and for the worst-case scenario volume of 15,000 (no hedge, forward contract, or option contract)

a) if the exchange rate remains at $1.16/€?

b) if the exchange rate will be $1.25/€?

c) if the exchange rate will be $1.11/€?

d) What is the overall best strategy? Why?

Answer 1

1.

a) total projected costs :
Scenarios	Worst case	Best case	Expected
Sales volume	15,000.00	50,000.00	30,000.00
Cost per student in euro	2,000.00	2,000.00	2,000.00
Exchange rate	1.16	1.16	1.16
Cost per student in $	1,724.14	1,724.14	1,724.14
Total costs in $	25,862,068.97	86,206,896.55	51,724,137.93

b) total projected costs if forward contract is used:
Scenarios	Worst case	Best case	Expected
Sales volume	15,000.00	50,000.00	30,000.00
Cost per student in euro	2,000.00	2,000.00	2,000.00
forward exchange rate	1.175	1.175	1.175
Cost per student in $	1,702.13	1,702.13	1,702.13
Total costs in $	25,531,914.89	85,106,382.98	51,063,829.79

c)

total option premium for each scenario
Scenarios	Worst case	Best case	Expected
Sales volume (a)	15,000.00	50,000.00	30,000.00
Cost per student in euro (b)	2,000.00	2,000.00	2,000.00
Option strike price (c )	1.165	1.165	1.165
Option strike price in $ (d = a x b x c)	34,950,000.00	116,500,000.00	69,900,000.00
Option premium in $ (e = d x 2%)	699,000.00	2,330,000.00	1,398,000.00

2. a) Total costs = 35,000 x 1.16 x 2,000 = $ 81,200,000 (Baseline scenario)

b) Total costs = 35,000 x 1.25 x 2,000 = $ 87,500,000(Baseline scenario) - which is $ 6,300,000 more than the baseline case

c) Total costs = 35,000 x 1.11 x 2,000 = $ 77,700,000 (Baseline scenario) - which is $ 3,500,000 less than the baseline case

3. a) Total loss = (1.175-1.16) x 2,000 x 35,000 = $ 1,050,000

% of loss from hedging = $ 1,050,000 / $ 81,200,000 = 1.29%

b) Total benefit = (1.25-1.175) x 2,000 x 35,000 = $ 5,250,000

% of benefit from hedging = $ 5,250,000 / $ 87,500,000= 6%

c) Total loss = (1.175-1.11) x 2,000 x 35,000 = $ 4,550,000

% of loss from hedging = $ 4,550,000 / $ 77,700,000  = 5.85%