Suppose that you are part of the Management team at F. Mayer Imports. Fast forward a few

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Question:

Suppose that you are part of the Management team at F. Mayer Imports. Fast forward a few years and suppose that it is the end of December 2019 and a novel coronavirus that causes a respiratory illness was identified and reported to the World Health Organization. There is heightened uncertainty around the World.

You (as part of the management team) are reviewing F. Mayer’s hedging strategy for the calendar year 2020. Assume that F. Mayer’s management considers two scenarios:

Scenario 1 (Normal): The expected revenue from Australian sales in 2020 is A$180 million.

Scenario 2 (Low): The expected revenue from Australian sales in 2020 is 30% lower than the normal revenues.

Assume, in each scenario, that all revenues are realized at the end of December 2020. In addition to the import-related costs, F. Mayer has operational costs (e.g., paying employees, property costs) that equals 30% of the revenues. The import costs in 2020 in Euros are fixed at €70 million. Assume all costs are paid at the end of the year.

The current spot exchange rate is (bid-ask) €0.62/A$ - €0.63/A$ and forward bid-ask is €0.59/A$ - €0.60/A$. The call option premium is €0.026, and the call option strike price is €0.62. The put option premium is €0.025 and the put option strike price is €0.60. You are only allowed to buy options and you are not allowed to write options.

Your finance team has made the following 1-year forecasts for December 2020:

• bid-ask will be €0.62/A$ - €0.63/A$ if the investors (and speculators) risk levels remain unchanged during the pandemic. • bid-ask will be €0.51/A$ - $0.53/A$ if the investors (and speculators) consider the Euro a safe haven currency during the pandemic.

• bid-ask will be €0.88/A$ - $0.90/A$ if the investors (and speculators) consider the Australian dollar a safe haven currency during the pandemic

1. Assume that your team decided not to hedge F. Mayer’s currency exposure. What are your import costs in local currency under Scenario 1

a) if the exchange rate (bid-ask) remains at €0.62/A$ - €0.63/A$? Let’s call this the baseline case.

b) if the investors consider the Euro a safe haven currency during the pandemic? How does this compare to the baseline case?

c) if the investors consider the Australian dollar a safe haven currency during the pandemic? How does this compare to the baseline case?

2. Assume that your team decided to hedge F. Mayer’s currency exposure using forward contracts. What are your import costs in local currency under Scenario 1

a) if the exchange rate (bid-ask) remains at €0.62/A$ - €0.63/A$? How does this compare to the baseline case?

b) if the investors consider the Euro a safe haven currency during the pandemic? How does this compare to the baseline case?

3. Assume that your team decided to hedge F. Mayer’s currency exposure using option contracts. What are your import costs in local currency under Scenario 1

a) if the exchange rate (bid-ask) remains at €0.62/A$ - €0.63/A$? How does this compare to the baseline case? Clearly state the type of option you are using.

b) if the investors consider the Euro a safe haven currency during the pandemic? How does this compare to the baseline case?

4. Assume that the Scenario 2 (Low) took place in 2020 and the exchange rate (bid-ask) remains at €0.62/A$ - €0.63/A$ during the pandemic. What is your cash flow (profit) and cash flow as a percentage of revenues if you

a) do not hedge the exchange rate risk?

b) hedge the exchange rate risk using forward contracts?

c) hedge the exchange rate risk using options contracts?

5. Assume that the Scenario 2 (Low) took place in 2020 and the Euro became a safe haven currency during the pandemic. What is your cash flow (profit) and cash flow as a percentage of revenues if you

a) do not hedge the exchange rate risk?

b) hedge the exchange rate risk using forward contracts?

c) hedge the exchange rate risk using options contracts?