The ABC company made a contract to purchase materials with a manufacturer in Italy for EUR 200,000.
Question:
The ABC company made a contract to purchase materials with a manufacturer in Italy for EUR 200,000. The purchase was scheduled with payment due in three months. The ABC company is considering several hedging alternatives to reduce the exchange rate risk arising from the purchase. To help the firm make a hedging decision you have gathered the following information.
The spot exchange rate is EUR/USD 1.25-1.35.
The three-month forward rate is EUR/USD 1.38-1.42.
The EUR three-month interest rates for the ABC are 7.25%-9.15%
The USD three-month interest rates for the ABC are 6.14%-8.15%
The cost of capital for the ABC company is 10% (opportunity cost)
Three-month call options for EUR 10,000; strike price USD 1.42, premium
price is 1.5% of the option size. The delta of this option is 0.4. The forecast for three-month spot rates is EUR/USD 1.42-1.57
The budget rate, or the highest acceptable purchase price for this project, is USD290,000 or EUR/USD 1.45
(a) What is the expected USD amount paid by the ABC to the Italian manufacturer in three months according to the forecast spot rates?
(b) What is the break-even exchange rate of EUR/USD making no difference for using the money market hedge or using the forward hedge?
(c) What is the USD cost of using the call options to hedge the payment risk in three months? (Hint: the interest cost for the call premium is the cost of capital)
(d) Which hedging method is much more appropriate for the ABC company to adopt in terms of USD toward payable hedging once the forecast spot rates are correct? (Please prepare a quantitative comparison table to illustrate your answer.)