Question

Frank sold his house in Paris to a US-based company, and billed $4 million payable in three months. Considering the euro proceeds from international sales, Frank would like to hedge an exchange risk. The current spot exchange rate is $1.25/€ and the three-month forward exchange rate is $1.30/€ at the moment. Frank can buy a three-month put option on US dollars with a strike price of €0.80/$ for a premium of €0.01 per US dollar. Currently, the three-month effective interest rate in the euro zone is 2.5% per annum and in the US is 3.0% per annum.

1. What action does Frank need to take if using money market instruments? What would be the guaranteed euro proceeds from the American sale in this case?

2 .If Frank decides to hedge using put options on US dollars, what would be the ‘expected’ euro proceeds from the American sale? Assume that Frank regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

3. At what future spot exchange rate do you think it will be no different for Frank to take either the option and money market hedge?

Answer 1

COMPUTATION OF NET PROCEEDS RECEIVABLE FROM SALE PROCEEDS AFTER 3 MONTHS

1. USING MONEY MARKET HEDGE

1ST STEP FRANK WILL TAKE THE LOAN AT INTEREST RATE 3% P.A FOR 3 MONTHS SO THAT TOTAL $ 4 MILLION IS PAYABLE AFTER 3 MONTHS = $4000000/1.0075= $3970223 (ROUNDED OFF)

2ND STEP CONVERT DOLLAR INTO EURO USING SPOT RATE 1 EURO = 1.25 $

=3970223/1.25= 3176178 EURO

3RD STEP INVEST THAT MONEY FOR 3 MONTHS AT RATE 2.50% P.A AND GET MONEY AFTER 3 MONTH WITH INTEREST

=3176178(1.00625)= 3196029 EURO

4TH STEP REPAY $4 MILLION LOAN WITH THE AMOUNT RECEIVABLE FROM THE PURCHASER AT THE END OF 3 MONTHS

TOTAL AMOUNT RECEIVED IN THIS CASE = 3196029 EURO

2. USING FORWARD CONTRACT F.R. 1 EURO= 1.30$

AT 3 MONTH END TOTAL EURO RECEIVED = 4000000/1.30 = 3076923 EURO

3. USING OPTION STRATEGY

1ST STEP PAY PREMIUM BY TAKING LOAN AT RATE 2.5% PA FOR 3 MONTHS

PREMIUM PAYABLE = 4000000*0.01= 40000 EURO

2ND STEP CALCULATE FUTURE SPOT RATE

= S.R X(1+Q)/(1+B) S.R = SPOT RATE, Q = PRICE CURRENCY INTT. RATE, B= BASE CURRENCY INTT. RATE

=.80X(1.00625)/1.0075 =0.799 EURO

FUTURE SPOT RATE =1$=0.799 EURO

3RD STEP FRANK WILL USE THE OPTION AND SELL AS PER OPTION CONTRACT

=400000*0.80= 3200000 EURO

4TH STEP PAY LOAN TAKEN FOR PREMIUM WITH INTEREST

=40000(1.00625)=40250 EURO

5TH NET PROCEEDS RECIVABLE =3200000-40250=3159750

1. GUARANTEED EURO PROCEEDS A) USING MONEY MARKET HEDGE = 3196029 EURO

B) USING FORWARD CONTRACT = 3076923 EURO

2. USING OPTION CONTRACT EXPECTED EURO NET PROCEEDS = 3159750 EURO

3. APPROX 1$ = 0.809 EURO THE POSITION WILL BE INDIFFERENT FOR FRANK. PREMIUM AND INTT. THEREON IS INCLUDED WHILE CALCULATING THIS.

A. MONEY MARKET HEDGE PROCEEDS =3196029 EURO

B. PREMIUM WITH INTT. PAYABLE = 40250 EURO

C. (A+B)/4000000=0.80906975=0.809 EURO APPROX