Question

Indiana Company expects to receive 5 million euros in one year from exports.It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar cash flows received as a result of using the following strategies:

a). unhedged strategy

b). money market hedge

c). option hedge

The spot rate of the euro as of today is $1.30. Interest rate parity exists. Indiana Company uses the forward rate as a predictor of the future spot rate. The annual interest rate in the U.S. is 6% versus an annual interest rate of 4% in the eurozone. Put options on euros are available with an exercise price of $1.25, an expiration date of one year from today, and a premium of $.04 per unit. Estimate the dollar cash flows it will receive as a result of using each strategy. Which hedge is optimal?

Answer 1

a.
Cash flow if remains unhedged
Forward rate	Spot rate*(1+Rd)/(1+rf)
Forward rate	1.30*(1.06/1.04)
Forward rate	1.30*1.019231
Forward rate	$1.33
Amount of euro to be received	5000000
Forward rate	1.33
Cash flow	$6,625,000
b.
Cash flow in money market hedge
Amount of receivables	$5,000,000
Interest rate for Euro	4%
Amount borrowed in Euro	$4,807,692
$ received from converting	$6,250,000
Deposit rate in U.S	6%
Cash flow in money market hedge	$6,625,000
c.
Cash flow in options
Amount of receivables	5000000
Amount received per unit	$1.29	(1.33-0.04)
Cash flow from options	$6,425,002
The put option would not be exercise as future spot rate is higher than strike rate
The money market hedge is optimat as it provides higher cash flow