ABB Group. On May 1, ABB Group, a wholly owned subsidiary of Asia Power Generation Corporation

(Philippines), sold a 20-megawatt transformer to Roma Italia SpA of Italy for €5,000,000, payable as €2,500,000 on September 1 and €2,500,000 on December 1. ABB derived its price quote of

€5,000,000 on April 1 by dividing its normal Philippine peso sales price of PHP279,750,000 by the then current spot rate of PHP55.9500/€.

By the time the order was received and booked on June 1, the euro had strengthened to PHP56.0500/€, so the sale was in fact worth €5,000,000 * PHP56.0500/€ =

PHP280,250,000. ABB had already gained an extra PHP500,000 from the favorable exchange rate movements.

Nevertheless, ABB’s vicepresident of finance now wondered if the firm should hedge against a reversal of the most recent trend of the euro. Four approaches were possible:

1. Hedge in the forward market: The 3-month forward exchange quote was PHP56.1500/€ and the 6-month forward quote was PHP57.0500/€.

2. Hedge in the money market: ABB could borrow euros from the Munich branch of its Philippine bank at 6.00% per annum.

3. Hedge with foreign currency options: September put options were available at a strike price of PHP56.0500/€ for a premium of 1.5%

per contract, and December put options were available at PHP56.0500/€ for a premium of 1.1%. September call options at PHP56.0500/€

could be purchased at a premium of 2.0%, and December call options at PHP56.0500/€ were available at a 1.7% premium.

4. Do nothing: ABB could wait until the sales proceeds were received in September and December, hope the recent strengthening of the euro would continue, and sell the euros receives for Philippine pesos in the spot market.

ABB estimates the cost of equity capital to be 10% per annum. As a moderate-sized firm, ABB is unable to raise funds with long-term debt. Average euro denominated government bonds yield 1.0% per annum. What should ABB do?