Question

Plains States Manufacturing has just signed a contract to sell agricultural equipment to Boschin, a German firm, for euro 1,250,000. The sale 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, Plains States 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 $1.40/euro • The six month forward rate is $1.38/euro • Plains States' 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 deposit 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 deposit rate is 6% (or 3% for 6 months) • December put options for euro; strike price $1.42, premium price is 1.5% • Plains States' forecast for 6-month spot rates is $1.43/euro

Answer the following questions: 1) If Plains States chooses not to hedge their euro receivable, what is the $ amount they receive in six months?

Answer 1

Solution- 1

If Plains states chooses not to hedge their euro receivable, than after 6 months they will have to convert the euros received into USD at the spot rate that would exist after 6 months. The company's estimate for the spot rate after 6 months is $1.43/Euro. Therefore, the $ amount to be received after 6 months is calculated as follows:

$ receivable after 6 months= Euros receivable*Expected spot rate after 6 months

$ receivable after 6 months= 1,250,000*1.43= $1,787,500