Question

Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss client a choice of paying $10,000 or SF 15,000 in three months.

(1) What is the best way for Baltimore Machinery to deal with its foreign currency exposure?

(2) In the example, Baltimore Machinery effectively gave the Swiss client a free option to pay in $ or in SF. If the spot rate turns out to be $0.62/SF in three months, what is the value of this free option for the Swiss client?

(3) At what future spot rate will the Swiss firm choose to pay with $?

Answer 1

1)

As per the Option, he has the right to pay $10000 or SF15000. Therefore, Exchange Rate as per Option is 10000/15000 = $0.6667/SF

If in any way, be it sopt rate after 3 months, or 3-months forward contract's price today, or via Money Market Hedge, Baltimore can buy More than $0.6667 for 1 SF, then he should choose an option to pay in $, or he should pay in SF.

2)

If Future Spot rate is $0.62/SF, then Value of this Option(in SF) is 15000-[10000/0.62] = 15000-16129.03 = -SF1129.03

3)

At the Future Spot Rate of MORE THAN $0.6667/SF, Baltimore will choose to pay in $.