AFF 621 Lecture Notes - Lecture 1: Foreign Exchange Spot, Exchange Rate, Foreign Exchange Market
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Coleman needs 100,000 euros in 1 year, then it could convert dollars to euros and deposit the euros in a bank today.The Coleman purchasing team received this price quote of â¬100,000 today where the current spot rate was $1.1800/â¬, which equates to the U.S. dollar price of $118,000.
Coleman's director of finance now wondered if the firm should hedge against more fluctuation in the exchange rate.
Three approaches were possible:
1) Hedge in the forward market. The 1-year forward exchange quote was $1.20/â¬.
2) Hedge in the money market. Coleman could borrow U.S. dollars from its U.S. bank at 7.00% per annum. The EU investment rate is 9.00% per annum.
3) Hedge with foreign currency options. The day the Euros are needed the call options at $1.2000/⬠could be purchased for a premium of $0.03. (Note: First you need to figure out the option premium in percentage. The spreadsheet cell D32 is not set-up for USD)
Discuss if Coleman should hedge its transaction exposure of EUR 100,000. If you recommend that the company should hedge, which of the hedging alternatives would better serve Northwind shareholders?
Assumptions | Value | |
1-year A/P in ⬠| ? | |
Spot rate, ($/â¬) | ? | |
1-year forward rate, ($/â¬) | ? | |
EU investment rate | ? | |
borrowing rate, USD, per annum | ? | |
Coleman's WACC | 10.000% | |
Time to maturity (in months) | 12.00 | |
Options on Euro: 1-year Strike price, ($/â¬) | Call Option | |
Strike price ($/£) | ? | |
Option premium ? Solve this using step by step calculations |