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Comparison of Techniques for Hedging Receivables.
Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one?year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows:
Future Spot Rate Probability
$.58 20%
.63 50
.67 30
Assume that one?year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One?year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates:
U.S. Singapore
Deposit rate 7% 4%
Borrowing rate 8 5
Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position.
ANSWER:
Forward hedge
Money market hedge
Option hedge
Possible Spot Rate
Option Premium per Unit
Exercise
Yes or
No?
Amount Received per Unit (also accounting for premium)
Total Amount Received for S$500,000
Probability
Unhedged Strategy
Possible Spot Rate
Total Amount Received for S$500,000
Probability
ANSWER:
Forward hedge
Money market hedge
Option hedge
Amount Paid Total
Option per Unit Amount
Possible Premium Exercise (including Paid for
Spot Rate per Unit Option? the premium) S$1,000,000 Probability
Unhedged Strategy
Possible Total
Spot Rate Amount Paid Probability
Topics in International Finance Problem Set 5 - Solutions Q5. Comparison of Techniques for Hedging Receivables. a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows: Future Spot Rate Probability $.61 20% .63 50 .67 30 Assume that one-year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore Deposit rate Borrowing rate 8% 9 5% 6 Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position. ANSWER: Forward hedge Sell S$500,000 × $.62 = $310,000 Money market hedge 1. Borrow S$471,698 (S$500,000/1.06 = S$471,698) 2. Convert S$471,698 to $283,019 (at $.60 per S$) 3. Invest the $283,019 at 8% to earn $305,660 by the end of the year Put option hedge (Exercise price = $.63; premium = $.04) Page 1 of 6 Amount Received per Unit (also accounting for premium) Option Premium per Unit Possible Spot Rate Total Amount Received for S$500,000 Exercise Probability $.61 $.04 Yes $.59 $295,000 20% $.63 $.04 Yes or No $.59 $295,000 50% $.67 $.04 No $.63 $315,000 30% The forward hedge is superior to the money market hedge and has a 70% chance of outperforming the put option hedge. Therefore, the forward hedge is the optimal hedge. Unhedged Strategy Possible Spot Rate Total Amount Received for S$500,000 Probability $.61 $305,000 20% $.63 $315,000 50% $.67 $335,000 30% When comparing the optimal hedge (the forward hedge) to no hedge, the unhedged strategy has an 80% chance of outperforming the forward hedge. Therefore, the firm may desire to remain unhedged. b. Assume that Baton Rouge, Inc. expects to need S$1 million in one year. Using any relevant information in part (a) of this question, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position. ANSWER: Forward hedge Purchase S$1,000,000 one year forward: S$1,000,000 × $.62 = $620,000 Money market hedge 1. Need to invest S$952,381 (S$1,000,000/1.05 = S$952,381) 2. Need to borrow $571,429 (S$952,381 × $.60 = $571,429) 3. Will need $622,857 to repay the loan in one year ($571,429 × 1.09 = $622,857) Call option hedge (Exercise price = $.60; premium = $.03) Page 2 of 6 Amount Paid Option Total per Unit Amount Possible Premium Exercise (including Paid for Spot Rate per Unit Option? the premium) S$1,000,000 $.61 $.03 Yes $.63 $630,000 .63 .03 Yes .63 630,000 50 .67 .03 Yes .63 630,000 30 Probability 20% The optimal hedge is the forward hedge. Unhedged Strategy Total Possible Amount Paid Spot Rate for S$500,000 Probability $.61 $610,000 20% .63 630,000 50 .67 670,000 30 The forward hedge is preferable to the unhedged strategy because there is an 80 percent chance that it will outperform the unhedged strategy and may save the firm as much as $50,000.
