Central Valley Transit Inc. (CVT) has signed a contract to purchase light rail vehicles from a manufacturer in Germany for €3,000,000. The purchase was made in June, with payment due in December six months later. Since this is a fairly large contract for the firm and the contract is in euros rather than dollars, CVT is considering various hedging alternatives to mitigate the exchange rate risk from the sale. You have collected the following information to help the firm make a hedge decision.

∙ The spot exchange rate is $1,250/euro.

∙ The six-month forward rate is $1.22/euro.

∙ CVT's cost of capital is 11%

∙ Euro zone 6-month borrowing rate 9% (or 4.5% for 6 months)

∙ Euro zone 6-month lending rate 7% (or 3.5% for 6 months)

∙ US 6-month borrowing rate 8% (or 4% for 6 months)

∙ US 6-month lending rate 6% (or 3% for 6-months)

∙ December call options of 750,000 Euros; strike price $1.28, premium price 1.5%

∙ CVT's 6-month spot interest rate estimate of $1.27/euro

∙ The budget rate or highest acceptable purchase price for this project is $3,900,000 or $1.30/euro.

 What is the cost of CVT holding a call option for a euro receivable contract? (Note: Calculate the cost in future value dollars and consider the firm's cost of capital as the appropriate interest rate for calculating future values.)

Answer rating: 100% (QA)

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