Question

Part A: Zydeco Guitars is a Canadian artisan company produces high-end guitars for musicians and recording companies. It has currently negotiated a sale of guitars worth USD230,000 to Drive Records based in Chicago to be paid in 6 months upon delivery. The current spot rate of exchange is CD$1.15=US$1, and the six-month forward rate is CD$1.25=US$1.

A) If the actual spot rate 6 months later is CD$0.75=US$1 due to an unexpected surge in the Canadian economy, what is Zydeco’s profit/loss on the hedge?

B) What if instead the Canadian economy dipped, and the spot rate 6 months later is CD$1.50=US$1?

C) the probability of the spot rates in A)and B)above is 50% either way, should Zydeco hedge or not?

Answer 1

Selling Price of Guitar = USD 2,30,000

Forward Rate after 6months = 1$US = 1.25CD$

a) Actual spot rate after 6m = 1 $US =0.75 CD$

If the company hedge its position then the sales reciept = 1.25CD$*2,30,000=2,87,500CD$

If its not hedge its position then the saes reciept = 0.75CD$*2,30,000=1,72,500CD$

The profit from the hedging is =2,87,500CD$- 1,72,500CD$= $1,15,000

b)Actual spot rate after 6m = 1 $US =1.50 CD$

If the company hedge its position then the sales reciept = 1.25CD$*2,30,000=2,87,500CD$

If it not hedge its position then the sales reciept = 1.50CD$*2,30,000=3,45,000CD$

The loss from the hedging is =2,87,500CD$- 3,45,000CD$= $57,500

c)

Gain/Loss (x)	Probablity (p)	Px
CD$115000	0.5	CD$57500
CD$ 57500	0.5	-CD$28750

Total CD$28750

Expected Value = CD$28750/1

= CD$28750

So it is advisable to hedge the position .