Velodyne Inc. has just signed a contract to sell LIDAR systems to BMW for 100,250,000 Euro. The sale was made in June, with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, Velodyne considers several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make the hedging decision, you have gathered the following information:

the spot exchange rate is EUR/USED1.140

The six-month forward rate is EUR/USED 1.1480

Velodyne's cost of capital is 10%

the Eurozone 6-month borrowing rate is 7% per annum (or 3.5% for 6 months)

The Eurozone 6-month lending rate is 5% per annum (or 2.5% for 6 months)

The US 6-month borrowing rate is 6% per annum (or 3% for 6-months)

The US 6-month lending rate is 4.5% per annum (or 2.25% for 6 months)

December put options for EUR with strike price $1.18 has a premium is 1.5%

Velodyne forecast for 6 month spot rates is EUR/USD 1.19. The budget rate, or the lowest acceptable sales price for this project, is USD114,285,000 or EUR/USD 1.14.

Compare the following hedge alternatives:

a) hedging with the forward contract

b) hedging by using a money market hedge

c) hedging by using the EUR/USD 1.18 strike put option

Briefly discuss the pros and cons of each alternative and make a recommendation to Velodyne management

Answer rating: 100% (QA)

To compare the hedging alternatives lets calculate the outcomes for each option and discuss their pros and cons a Hedging with the forward contract With the forward contract Velodyne can lock in the e... View the full answer