NATIONAL (UAE)’s trading currency is Dirham (AED). Today, the company XYZ from the UAE placed a US$10,000,000 order to purchase a water purification system from Bruce Co, U.S.A. This order is of significant size compared to the total budget of XYZ.

The delivery term is 4 months, and upon testing and certification, the company will make full payment 2 months later.

Today, RHB Bank (in the UAE) has offered the following quotes:

Spot rate                                       4.20 UAE / US$

1-month forward rate                    4.21 UAE / US$

6-month forward rate                    4.22 UAE / US$

1-month UAE deposit rate             2.45% per year

1-month UAE borrowing rate        4.45% per year

6-month UAE deposit rate 2.55% per year

6-month UAE borrowing rate        4.75% per year

1-month US$ deposit rate 3.5% per year

1-month US$ borrowing rate         5.5% per year

6-month US$ deposit rate               3.65% per year

6-month US$ borrowing rate         5.85% per year

1-month at-the-money put option on 1 million USD at 1.5% premium

1-month at-the-money call option on 1 million USD at 1.5% premium

6-month at-the-money put option on 1 million USD at 2% premium

6-month at-the-money call option on 1 million USD at 2% premium

Required:

Discuss the risk of staying unhedged. Compare at least three different hedging strategies and recommend which one the company should adopt if the forward rate is a good prediction of the future rate in 6 months. Show your workings clearly. Conclude which strategy is the best if the spot rate in 6 months is 4 UAE/US$.

You may illustrate your findings with a diagram (ideally a graph in excel or a picture taken with your phone that you insert in a Word file for instance).

Bonus: Explain how you would change your solution if instead of one exchange rate, you were given a bid-ask spread for the exchange rate.

Spot rate                                         BID = 4.19 UAE / US$ - ASK= 4.20 UAE / US$

1-month forward rate                   BID = 4.20 UAE / US$ - ASK= 4.22 UAE / US$

6-month forward rate                   BID = 4.21 UAE / US$ - ASK= 4.23 UAE / US$