Mr. Fulton, a collector based in the United States, just sold one of his Stradivarius violins to
Question:
Mr. Fulton, a collector based in the United States, just sold one of his Stradivarius violins to a German buyer for €10,000,000, payable in six months. The current spot exchange rate is $1.05/€ and the six-month forward exchange rate is $1.10/€. Mr. Fulton can buy a six-month put option on euros with a strike price of $1.08/€ for a premium of $0.01 per euro. Currently, the six-month euro interest rate is 4% per annum and the six-month USD interest rate is 5% per annum.
(a) If Mr. Fulton hedges his euro receivables with a forward market hedge, how much is he expected to receive in USD in six months?
(b) Suppose Mr. Fulton hedges his euro receivables with an options market hedge.
(i) How much does he need to pay now to buy the put option?
(ii) Using the current forward exchange rate as the predictor for the future spot exchange rate, how much is Mr. Fulton expected to receive in USD in six months, after taking the option costs into account?
(c) At what future spot exchange rate do you think Mr. Fulton will be indifferent between the option and forward market hedge?
(d) On a graph, plot the dollar receivables of the sale against the future spot exchange rate under both the option and forward market hedges. Label on the graph the indifference point (if any) between the option and forward market hedge.
(e) If Mr. Fulton hedges his euro receivables with a money market hedge, how much is he expected to receive in USD in six months?
(f) At what future spot exchange rate do you think Mr. Fulton will be indifferent between the option and money market hedge?
(g) On a graph, plot the dollar receivables of the sale against the future spot exchange rate under both the option and money market hedges. Label on the graph the indifference point (if any) between the option and money market hedge.