1. (20 points) Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale: 1) hedge in the forward market; 2) hedge in the money market; or 3) hedge in the options market. To help the firm make a hedging decision you have gathered the following information.

The spot exchange rate is $1.25/euro

The six month forward rate is $1.27/euro

The Euro zone rate is 7% p.a. (or 3.5% for 6 months)

The U.S. rate is 8% p.a. (or 4% for 6 months)

The six-month call or put options for euro with strike price $1.27, premium is 1.5%.

1. What action does CVT need to take for each of the three hedging alternative?
2. Calculate the future dollar payment under the three alternatives if the spot exchange rate becomes $1.28/euro in six months.
3. Calculate the future dollar payment under the three alternatives if the spot exchange rate becomes $1.26/euro in six months.
4. At what future spot exchange do you think CVT will be indifferent between the option and money market hedge?
5. At what future spot exchange do you think CVT will be indifferent between the option forward hedge?
6. At what dollar interest rate do you think CVT will be indifferent between the forward and money market hedge?
7. Draw and label a diagram to show the future dollar payment under the three alternatives