ABC imports special herbal oil from Morocco to the U.S. The fixed operating costs are USD 300,000 per year. The contracted variable costs are MAD (Moroccan Dirham) 400 per gallon of oil sold. As a finance manager, you have decided to set the catalog price for the oil at USD 80 per gallon, which is good for one year. You are not sure about the quantity of oil that ABC can sell in the coming year, but your best estimate is 50,000 gallons. Depending on the competition and the overall demand, the sale quantity can be as low as 10,000 gallons or as high as 90,000 gallons. For simplicity, please assume that the sale revenues as well as the costs will arrive at the end of the year.

MAD is pegged to a basket of two currencies—USD and EUR. Your bank estimates that one MAD equals approximately USD 0.0234 plus EUR 0.0731. The spot exchange rates and the 1-year zero-coupon interest rates in different currencies are as follows:

 

So that USD/MAD = 8.000 means MAD 8.000/USD and EUR/MAD = 11.120 means MAD 11.120/EUR. Please also ignore the bid-ask spreads and assume that you can trade at these spot rates, and for this reason, no arbitrage would further imply that the exchange rate between USD and EUR is 11.120/8.000 = USD 1.390/EUR.

You think that the future exchange rate can be low (MAD 6.500/USD), medium (MAD 8.314/USD), or high (MAD 10.500/USD). You consider hedging your currency exposure using forward contracts and options. The ATMF call and put options on MAD (expiring in one year) both trade at USD 0.008 (per MAD).

 

1. What is 1-year forward rate for USD/MAD?

2. What 1-year forward rate for EUR/MAD?

3. What is the 1-year forward rate for EUR/USD?

4. In order to hedge your currency risk, which currency would you buy and which would you sell in the forward market?

5. In order to hedge your currency risk, which option would you buy or sell?

(Traders' Convention) Spot Exchange Rate One-Year Interest Rate USD/MAD EUR/MAD 8.000 11.120 USD 2.00% EUR 3.00% MAD 6.00%