1. CIRP with bid-ask prices (25 points)

Suppose you are a sales manager for Johnson & Johnson, an American pharmaceutical and consumer goods manufacturer. You have just signed a deal to export pharmaceutical products to a German distributor. The deal is denominated in euro, and you will receive 900,000 when you deliver the products in 90 days. Assume that you can borrow and lend over the 90-day period at 0.45% in US dollars and at 0.60% in euro. In addition, you obtain the following bid-ask quotes from a currency dealer:

• Current spot rate: USDEUR 1.2324/1.2326
• 90-day forward rate: USDEUR 1.2259/1.2285

1) In order to eliminate your transaction exchange risk, you could do a forward hedge. Should you buy or sell a euro forward? What are the euro and dollar cash flows associated with the forward hedge?

2) Alternatively, you could do a money market hedge. Clearly explain each step and calculate the resulting cash-flows now and in 90 days. Compare the two hedging alternatives, which one is superior?

3) Assume that the spot rate, forward rate, and the dollar interest rate are correct. Determine what euro interest rate would make your company indifferent between the two alternatives in 1) and 2).

4) Give an example of an action Johnson & Johnson could take to create a natural hedge for this transaction exchange risk.

5) If Johnson & Johnson used options to hedge the risk, which of the following types of options would the company want to purchase? (There may be more than one correct answer, no explanation required for this question.)

a. EUR put option against USD

b. EUR call option against USD

c. USD put option against EUR

d. USD call option against EUR