Question

ADG has a ¥2,400 million payable in 4 months. The relevant market data include: The current spot exchange rate of $0.01274/¥, four-month forward exchange rate of $0.01274/¥, four-month call option on yen with the strike price set at 127 cents for 100 yen that is selling for 3.11 cents per 100 yen. ADG’s borrowing interest rate in dollars is 0.62%, while lending interest rate in yen is 0.18%. Compare three alternative hedging methods as in our discussions in the textbook: Forward, money market, and option hedges.

Answer 1

Using forward hedge the dollar cost of the payable can be determined by converting the payable to $ at the forward rate:

2400000000*0.01274

=$30576000

Using money market hedge we have to borrow dollars which will be equal to the present value of the payment.

[2400000000/(1+0.0018*117/360]*0.01274

=$30558123.50

Amount of loan at the end of 4 months=30558123.50(1+0.0062*117/360)

=$30619698.12

Hence the dollar cost=$30619698.12

Using option we have a strike price of $0.0127/Yen

Option is trading at 3.11 cents per 100 Yen

Cost = (2400000000*0.000311)[1+0.0057(117/360)]

=$746400*1.0018525

=$747783

Risk arises when Yen appreciates and so when it is beyond 0.00127$/Yen ADG will exercise the option and the payable amount will be (2400000000/0.0127)+747783

=$31227783

Hence it is clear the cost will be least in case of a forward hedge.