FIN 353 International Financial Management



FINC 445 International Financial Management

Homework Assignment II

You can provide your answers by expanding the space between questions.

You must show your work and/or explain your answers sufficiently to get credit.

Foreign Currency Derivatives

Transaction Exposure

1. On January 15, your firm anticipates that it will need Australian dollars (A$) in mid March when an order is made from an Australian supplier. Therefore, you buy a futures contract on A$ with a March settlement date. (A future contract is for A$100,000). At the time of the purchase the price of the futures contract is $0.5300/A$. Sometime in February, your firm revise production plan and eliminate the potential order from Australian supplier. Now, you have to close the position on A$ futures by selling a futures contract on A$. At the time of the sale the futures contract priced at $0.5000/A$. What is the amount of profit or loss after these transactions?

For the following options please fill out the tables.

2. Buying a call option (Long Call):

|Buying a Call Option on British Pound (Long Call) |

|You have a right to buy British Pound at the Strike Price |

|Strike Price |$1.5000 | | | |

|Premium |$0.0200 |(Cost of Buying a call option) |

|Contract Size |£62,500 | | | |

|Net Profit = Maximum [ (Spot Rate - Strike Price), 0 ] - Premium |

|Spot Rate |Net Profit or Loss per Pound |Total |

|$1.4000 | | |

|$1.6000 | | |

3. Writing (selling) a call option (Short Call):

|Writing a Call Option on British Pound (Short Call) |

|You have given someone else a right to buy British Pound from you |

|Strike Price | |$1.5000 | | | |

|Premium | |$0.0200 |(Proceeds from sale of a call option) |

|Contract Size |£62,500 | | | |

|Net Profit = - Maximum [ (Spot Rate - Strike Price), 0 ] + Premium |

|Spot Rate |Net Profit or Loss per Pound |Total |

|$1.4000 | | |

|$1.6000 | | |

4. Buying a put option (Long Put):

|Buying a Put Option on British Pound (Long Put) |

|You have a right to sell British Pound |

|Strike Price | |$1.5000 | | | |

|Premium | |$0.0300 |(Cost of Buying a put option) |

|Contract Size |£62,500 | | | |

|Net Profit = Maximum [ (Strike Price - Spot Rate), 0 ] - Premium |

|Spot Rate |Net Profit or Loss per Pound |Total |

|$1.4000 | | |

|$1.6000 | | |

5. Writing (selling) a put option (Short Put):

|Writing a Put Option on British Pound (Short Put) |

|You have given someone else a right to sell British Pound to you |

|Strike Price | |$1.5000 | | | |

|Premium | |$0.0300 |(Proceeds from sale of a put option) |

|Contract Size |£62,500 | | | |

|Net Profit = - Maximum [ (Strike Price - Spot Rate), 0 ] + Premium |

|Spot Rate |Net Profit or Loss per Pound |Total |

|$1.4000 | | |

|$1.6000 | | |

6. Assume the following information:

Annual U.S. interest rate is 16%

Annual British interest rate 18%

6-month forward rate is $1.5000/£

Spot rate is $1.4800/£

Assume that Oak Park Corp. from the United States will receive £400,000 in 180 days. Which hedging alternative would be better, a forward hedge or a money market hedge?

7. Assume that Lockheed Martin sells fighter planes to UK at a total price of £10,000,000 payable in one year. At the time of the sale you have gathered the following information:

|Annual US interest rate |6.10% |

|Annual UK interest rate |9.00% |

|Spot Exchange Rate |$1.50/£ |

|The forward exchange rate |$1.46/£ |

|Put option exercise price |$1.46/£ |

|Price of the option |$0.02/£ |

Complete the tables or determine hedging outcome.

a. Forward Hedge:

|Spot Exchange Rate at |Unhedged |Forward Hedge |Gain/Loss |

|Maturity | | |(Forward – Unhedged) |

|$1.35/£ | | | |

|$1.40/£ | | | |

|$1.45/£ | | | |

|$1.50/£ | | | |

|$1.55/£ | | | |

b. Money Market Hedge:

c. Option Hedge:

|Spot Exchange Rate at |Dollar Proceeds Considering the |Cost of Option |Option Net |

|Maturity |Decision on Option | | |

|$1.35/£ | | | |

|$1.40/£ | | | |

|$1.45/£ | | | |

|$1.50/£ | | | |

|$1.55/£ | | | |

Assume that the opportunity cost of option premium is 6.10%.

8. Assume that Plains Co. negotiated a forward contract to purchase £200,000 in 90 days. The 90-day forward rate was $1.4000/£. The pounds to be purchased were to be used to purchase British supplies. On the day the pounds were delivered in accordance with the forward contract, the spot rate of the British pound was $1.4400/£. What was the actual cost of hedging (the difference between dollar cost of the payables with and without hedging) the payables for this U.S. firm?

9. Assume that Maryville Co. has net payables of 200,000 Mexican pesos in 180 days. The Mexican interest rate is 14% per year, and the spot rate of the Mexican peso is $0.1000/Ps. Suggest how the U.S. firm could implement a money market hedge. Note you are not comparing alternatives in this case. You should focus on amount of US$ needed to cover the payables.

10. Plains States has just signed a contract to buy irrigation equipment from Wolfsburg, a German firm, for €1,500,000. The sale was made in March with payment due six months later in September. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, Plains States 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 $0.9314/€

• The six month forward rate is $0.9120/€

• The Euro zone 6-month borrowing rate is 8% per year (or 4% for 6 months)

• The Euro zone 6-month lending rate is 7% per year (or 3.5% for 6 months)

• The U.S. 6-month borrowing rate is 6% per year (or 3% for 6 months)

• The U.S. 6-month lending rate is 4% per year (or 2% for 6 months)

• Plains States' forecast for 6-month spot rates is $0.9020/€

• The budget rate, or the lowest acceptable sales price for this project, is $1,305,000 or $0.8700/€

• Six-month OTC put option; strike price is $0.8900/€, premium is 1.0%

• Six-month OTC call option; strike price is $0.8900/€, premium is 2.0%

a. What is the outcome of the Forward Hedge in six months?

b. Compare the outcome of Forward Hedge to no hedging with Plain States’ forecast as the actual spot rate in six months. Explain which alternative would be better for Plain States.

c. What is the outcome of Money Market Hedge in six months using available relevant rates?

d. What is the annual break-even rate between Forward and Money Market Hedges? Which alternative is better above the break-even rate?

e. Evaluate the outcome of Option Hedge with spot rates of $0.8600/€ and $0.9200/€ in six months when the contract expire. Use US borrowing rate as the opportunity cost of option premium.

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