OTC agrees to buy an equipment for 2,500,000. The purchase will be made in June 1
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Question:
- OTC agrees to buy an equipment for € 2,500,000. The purchase will be made in June 1st with payment due six months later in December 1st. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, OTc is considering to use either options or future to hedge the payment. (25 points, 5 points each)
To help the firm make a hedging decision you have gathered the following information:
The spot exchange rate is $1.0981/€.
December 1st call option for $1.1481/€ for a premium of 1%.
December 1st call option for $1.1258/€ for a premium of 1.5%.
OTC’s cost of capital is 12% per year.
- What is best choice between these two options? How much will OTC pay in the worst case situation in December 1st?
- If December 1st put option for $1.0889/€ for a premium of 1% and December 1st put option for $1.0932/€ for a premium of 1.5%. Will you change your answer for part a? If so, what will be OTC’s situation in December 1st?
- If the exchange rate in December 1st is $1.1198/€, assume OTC follows your recommendation for part b, how much will OTC pay?
- The December future contract has future price $1.1208/€ when the contract is signed, and the future will expire in 6 months at Dec 1st. Each future contract for EURO has €125,000 underline, and the initial margin is $2,565. Assume everything happens when the future expires. The spot exchange rate at future expiration is $1.1198/€. We ignore all daily cash settlements during the 6 months, how much will OTC receive or pay in aggregate for future contracts? How much will OTC cost for this payable with future contract?
- If the future contract will be expired at the end of December, and the future price at December 1st is 1.1250/€. The spot exchange rate at future expiration is $1.1198/€. We ignore all daily cash settlements during the 6 months, how much will OTC receive or pay in aggregate for future contracts? How much will OTC cost for this payable with future contract?
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