Question

Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. The spot exchange rate is $1.250/euro. The six month forward rate is $1.22/euro. CVT's cost of capital is 11%. The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months). The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months). The U.S. 6-month borrowing rate is 8% (or 4% for 6 months). The U.S. 6-month lending rate is 6% (or 3% for 6 months). December call options for euro 750,000; strike price $1.28, premium price is 1.5%. CVT's forecast for 6-month spot rates is $1.27/euro. The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro. If CVT locks in the forward hedge at $1.22/euro, and the spot rate when the transaction was recorded on the books was $1.25/euro, this will result in a "foreign exchange accounting transaction ________ of ________.

Select one:

a. loss; $90,000.

b. loss; €90,000.

c. gain; €90,000.

d. gain; $90,000.

Answer 1

CVT signed a contract for which it would have to pay 3,000,000 euros after 6 months.

Current sport exchange rate =$ 1.25/ euro

which means, you can buy 1 euro for $1.25 today.

Thus if we buy 3,000,000 today , it would cost = $1.25 * 3000000 = $3750000

This is the amount at which the transaction was recorded in the books of CVT for the contact signed

CVT's hedge : locked in forward hedge at a price = $1.22 / euro

this means that , CVT would be able to buy 1 euro at $1.22 after 6 months

Thus total cost in this case = $1.22*3000000 = $3660000

Hence, the actual cost for CVT after 6 months = $3660000

but the cost recorded by CVT in its books =  $3750000

Hence , it will result in a gain = $3750000 - $3660000 = $90,000 since the actual cost < the cost recorded