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NEC Inc. has sold computer components to a European company for €200,000 with payment due in 90 days. The following information is available:

*Spot exchange rate is €1 = $0.8100

*Management's forecast of the spot rate 90 days later: it is equally likely that the spot rate 90 days later will be €1 = $0.8000, €1 = $0.8050, or €1 = $0.8150

*90-day call option on €200,000 at exercise price of €1=$0.8100 and a $0.01 premium per €

*90-day put option on €200,000 at exercise price of €1=$0.8100 and a $0.01 premium per €

Suppose NEC Inc. wishes to hedge the dollar value of this transaction using one of the option contracts mentioned above.

(a). If NEC Inc. decides to hedge the exchange rate risk for this transaction, should NEC Inc. use the call option or the put option to hedge this transaction? Explain Briefly. (No calculation is needed here)

(b) Calculate the expected (or average) dollars received in 90 days for the option hedge you have chosen in part (a). Calculate the expected (or average) net profit (or loss) of this hedging strategy.

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Bunny Greenfelder
Bunny GreenfelderLv2
28 Sep 2019

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A U.S. firm will need £100,000 in 90 days to pay for British imports. The firm tries to hedge this transaction using a forward contract. We know the following information:

*Spot exchange rate: £1=$1.38.

*90-day forward exchange rate: £1 = $1.40 .

(a) Should this firm buy or sell a £ forward contract if it wants to eliminate the uncertainty of the dollar payment for this accounts payable (A/P)?

(b) If management's forecast of the spot rate 90 days later is:

Possible spot rate of £ in 90 days Probability

$1.30 25%

$1.36 25%

$1.40 30%

$1.45 20%

calculate the expected (or average) dollars paid in 90 days for the forward hedge you have chosen in part (a). Calculate the expected (or average) real costs of this hedging strategy relative to the no hedging scenario.

(c) Draw a net profit graph for this forward contract.

Wilson Ltd. Corporation will need to purchase 200,000 British pounds in 90 days. A call option exists on British pounds with an exercise price of $1.68, a 90 day expiration date, and a premium of $.04. A put option exists on British pounds, with an exercise price of $1.69, a 90 day expiration date, and a premium of $.03. Wilson plans to purchase options to cover its future payables. It will exercise the option in 90 days (if at all). It expects the spot rate of the pound to be $1.76 in 90 days. Determine the amount of dollars it will pay for the payables, including the amount paid for the option premium. SHOW ALL WORK

A) $360,000.

B) $338,000.

C) $332,000.

D) $336,000.

E) $344,000.

Suppose I own a French winery and that I am selling wine to theUS in 90 days for a price of $ 100,000. The current spot price is $1.3 / €. We are going to use the option market to hedge againstunfavorable exchange rate movements.

a. Considering this transaction only, what do we mean by'unfavorable' exchange rate movements?

b. Suppose it costs me € 70,000 to produce and transport thewine, if the exchange rate in 90 days is the same as the currentspot ($1.3/€), what is my profit in terms of euros? Suppose thatthere are options available that give me the option to exchange $for € at an exchange rate of $1.4 per €. Suppose these optionscollectively cost you € 5000. We are going to consider two separatescenarios: Scenario #1: In 90 days, the spot exchange rate is $1.2/€. Scenario #2: In 90 days, the spot exchange rate is $ 1.5/€.Reminder: The options give you the right, not the obligation toexchange your $100,000 at $1.4 per €

. c. Given Scenario #1, what is your total profit / loss fromselling the wine?

d. Given Scenario #2, what is your profit / loss from sellingthe wine?

e. Compare your answer in d) to your profit / loss if you,instead of hedging with options, went 'naked' as in not hedging atall (taking you chances in the spot market). Was it better to hedgeor go naked? Assume Scenario #2.

f. How would your answer change in e) above if the spot rate was1.6 $/€ (90 days from now) instead of the $ 1.5/€ as in scenario#2.

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