1. Delta is looking to purchase an A380 aircraft from Airbus and is concerned about the potential currency risk from being exposed to a euro liability 1 year from now. It is considering three hedging alternatives: forward hedge, money market hedge, and option hedge.

The current spot exchange rate is quoted at $1.28/. Currently, one-year money market rates are 4% in the U.S and 3.5% in the euro zone. A one-year call option on euros with a strike or exercise price of $1.27/ is selling at a premium of $0.03 per euro.

a. Should Delta use a long or short forward contract on the euro to hedge the currency risk? What should the no-arbitrage 1-year forward rate be?

b. At what future spot exchange rate 1 year from now will Delta be indifferent between the forward hedge (based on the no-arbitrage 1-year forward rate) and the option hedge?

c. Based on your solutions to parts a. and b. above, which hedging alternative should you choose?

d. It is now 6 months since you entered into the forward contract (assuming you chose to use the forward hedge alternative). The spot rate is $1.30/ and interest rates are the same as before. What is the value of your forward position?

e. It is now 6 months since you entered into the option contract (assuming you chose to use the option hedge alternative). The spot rate is $1.30/ and interest rates are the same as before. What is the intrinsic value of your option position if you choose to exercise it?