1. ABC has just signed a contract to sell equipment to a manufacturer in Germany with 2,500,000. The sell was made in January with payment due six months later in July. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, OTI is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information, and please compare each alternative and discuss how OTI should hedge the cash flows.

The spot exchange rate is EUR/USD 0.8924-27

To find 6-month forward rate, you call Banks, and they have access to Euro zoon 6-month interest rate of 6.5% - 8.5% pa, and the US 6-month interest rate of 5.5% - 7.5% pa

OTIs cost of capital is 11% (WACC)

The Euro zone 6-month money market rates are 7%-9% pa.

The U.S. 6-month money market rates are 6%- 8% pa.

The premium (option price) for December put options with strike price $.90 is 1.5%

The budget rate, or the lowest acceptable sale price for this project, is $2,175,000 or $0.87/

The July future contract has a future price of $0.895/ when the contract is signed, and the future will expire in 6 months. Each future contract for the EURO has 125,000 underline, and the initial margin is $2,565. We ignore all cash settlements during the 6 months and assume everything happens when the future expires.

There is also the tunnel forward (zero cost range option) strategic, The Put Option at strike price $0.87 and the Call Option at a strike price of $0.92 currently are traded at the same premium.

Hints: there are following hedge tools available in this question: Forward, Money Market Hedge (invest or rollover in WACC or saving rates), Option, Futures, and Tunnel Forward. (Each alternative worth 12 points and the discussion also worth 10 points, a total of 70 points)