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Case Assignment Questions "F. Mayer Imports: Hedging Foreign Currency Risk QUESTIONS: 1. Explain why hedging is important for F. Mayer Imports. Given that the current spot rate is EUR/AUD 0.6980, evaluate whether buying spot now is a viable hedging strategy. 2. Refer to Exhibit 3. Explain how the foreign exchange forward contract (FEC) works. 3. Refer to Exhibit 3. Demonstrate how solutions 1 and 2 may help F. Mayer Imports hedge their foreign currency risk. Include payoff diagrams in your explanation. 4. Based on your analysis of hedging strategies covered in questions 1, 2, and 3, recommend one solution to the company. Why do you think your recommendation is the best? EXHIBIT 3: THE E-MAIL PROPOSAL September 16, 2014 Hi Mr. Goode, On your request, please see the following indicative pricing on some AUD/EUR FX hedging solutions: All pricing is indicative and based off spot AUD/EUR 0.6980. The four (4) month FEC (Foreign Exchange Forward contract) is 0.6910 (spot of 0.6980 less 70 forward points). Solution 1Purchase an AUD Put/EUR Call Option Expiry Date: 2015-01-14 (four months) Value Date: 2015-01-16 Strike 1:0.6910 (at-the-money fwd) Strike 2:0.6860 (50 pips out-of-the-money (OTM)) Premium 1 2.13% of AUD face value (-146 AUD/EUR pips) Premium 2: 1.81% of AUD face value (-124 AUD/EUR pips) This solution gives you the right but not the obligation to buy EUR and sell AUD at the strike rate on the expiry date. On the expiry date, if the prevailing spot AUD/EUR is below the strike rate, then you will exercise the right to deal at the higher strike rate. Conversely, if the prevailing spot AUD/EUR rate is higher than the strike rate, then you will let the option lapse and buy EUR against the AUD in the spot market at the higher rate. I have provided you with two prices so you can see the relationship between premium and strike prices. Solution 2AUD/EUR Collar OptionBuy an AUD Put/EUR Call and Sell an AUD Call/EUR Put-Zero Premium Expiry Date: Value Date: B Put Strike: S Call Strike: B Put Strike: S Call Strike: 2015-01-14 (four months) 2015-01-16 0.6860 (50 pips below the FEC) 0.6942 0.6810 (100 pips below the FEC) 0.6983 This solution locks you into a range whereby you have a worst-case rate (bought put strike) and the capacity to participate in favourable AUD/EUR movements up to the sold call strike. Ideally, the worst-case rate would be your budget rate. I have provided you with indicative pricing on two collar structures so that you can compare two different ranges. Remember, a collar structure is an alternative to an FEC; therefore, when assessing participation benefits, use the FEC rate as the benchmark, not the spot rate. Solution 3AUD/EUR Knock-In ForwardBuy an AUD Put/EUR Call and Sell an AUD Call/EUR Put with Up-and-In Trigger-Zero Premium Expiry Date: Value Date: B Put Strike: S Call Strike: 2015-01-14 (four months) 2015-01-16 0.6890 (20 pips below the FEC) 0.6890 with up-and-in knock-in trigger at 0.7140 With this structure, your worst-case rate is 0.6890 (20 pips below the FEC). When the option starts, you only have a bought AUD put option with a strike of 0.6890. However, if 0.7140 trades at any time between the option start and expiry date, then you are knocked in to a sold AUD call option with a strike of 0.6890. Having a bought AUD put and sold AUD call option with the same strike creates a synthetic forward. So, in layman's terms, this structure gives you a worst-case rate that is 20 pips worse than the FEC; however, you have the opportunity to participate in the AUD/EUR all the way to the trigger rate of 0.7140. If 0.7140 does trade during the life of the option, then you have to deal at the common strike rate of 0.6890. Source: Company documents