Question

SMU Corp. will receive 1,000,000 New Zealand dollars (NZ$) in one year. It must decide whether to use options or a money market hedge to hedge this position. Use any of the following information to make the decision. Verify your answer by determining the estimate (or probability distribution) of dollar revenue to be received in one year for each type of hedge.

Spot rate of NZ$ = $0.54

One‑year call option: Exercise price = $0.50; premium = $0.07

One‑year put option: Exercise price = $0.52; premium = $0.03

	U.S.	New Zealand
One‑year deposit rate	9%	6%
One‑year borrowing rate	11	8
	Rate	Probability
Forecasted spot rate of NZ$	$0.50	20%
	0.51	50
	0.53	30

Answer 1

1. Dollar Revenue using Money Market hedge

1. Borrow Present Value of NZD receivables at NZD borrowing rate = Amount receivable / (1 + Interest) = 1000000 / 1.08 = NZD 925925.93
2. Convert PV of NZD into $ = PV of NZD * Spot Rate = 925925.93 * 0.54 = $500000.00
3. Invest US Dollar at US Deposit Rate and withdraw at maturity = $ * (1 + Interest) = 500000 * (1.09) = $545000
4. Pay off loan in NZD with receivable after 1 year

2. Dollar Revenue using Options

Forecasted future spot rate = Rate * respective Probability

Forecasted future spot rate = 0.50 * 20% + 0.51 * 0.50 + 0.53 * 0.30 = $0.514 / NZD

we are going to receive the NZD after one year. it means we are going to sell NZD after one year. Thus the appropriate option is Put Option. the forecasted future spot rate is less than exercise price thus the option is exercised

Dollar Revenue = Receivable * (Exercise price - premium)

Dollar Revenue = 1000000 * (0.52 - 0.03)

Dollar Revenue = $490000

Decision: The Cash flow in Money market hedge ($545000) is higher than Put option($490000). Thus Money Market hedge is recommended

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