Question

Narto Co. (a U.S. firm) exports to Switzerland and expects to receive 200,000 Swiss francs in one year. The one-year U.S. interest rate is 5% when investing funds and 7% when borrowing funds. The one-year Swiss interest rate is 9% when investing funds, and 10% when borrowing funds. The spot rate of the Swiss franc is $.80. Narto expects that the spot rate of the Swiss franc will be $.75 in one year. There is a put option available on Swiss francs with an exercise price of $.79 and a premium of $.02.

a. Determine the amount of dollars that Narto Co. will receive at the end of one year if it implements a money market hedge.

b. Determine the amount of dollars that Narto Co. expects to receive at the end of one year (after accounting for the option premium) if it implements a put option hedge.

Answer 1

a. Money Market Hedge :

• Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable. = (2,00,000 SWF /1.10) = 181818/-

• Convert the foreign currency into domestic currency at the spot exchange rate. = 181818 SWF = 227272.72 US $

• Place the domestic currency on deposit at the prevailing interest rate. = 227272.72*5% = 11364 INTEREST ( TOTAL = 227272.72+11364 = 238636 $ )

• When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest. = (238636*.75)-200000 = 21023 SWF LOSS

B. If he determined option hedge then he will receive 200000(0.79-.075-0.2) = 4000 $