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 currenciesUSD 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:

Traders conversion. USD/MAD EUR/MAD

SPOT EXCHANGE RATE 8.00 11.120

USD EUR MAD

ONE YEAR INTEREST RATE 2.00 3.00 6.00

Please note that the exchange rates (and below) are all presented in traders convention 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).

Please use the above information and the information specific to each sub-question to answer the following sub-questions.

Consider the forecast volume (50,000 gallons). What would happen under the three exchange rate scenarios if you (i) do not hedge, (ii) hedge 100% with forwards, or (iii) hedge 100% with options? Just as in the AIFS case, calculate the ECONOMIC IMPACTS in USD terms under different exchange-rate scenarios. Please assume that the forward rate is MAD 8.314/USD and use this rate as the ZERO-IMPACT scenario. And, for simplicity, please ignore the time value of the option premium.

Exchange rate USD/MAD (NO OF MAD PER USD). 6.500. 8.314. 10.500

NO HEDGE A B C

100% FORWARD HEDGE D E F

1005 OPTION HEDGE G H I

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