American Air, a major airline company headquartered in the U.S. has been evaluating several aircrafts to meet its future demand. After almost a year of careful study, on December 15, 2018, American Air has decided to place an order of 20 Airbus A380 jets for Euros 5.5 billion. The payment to Airbus, a France based aircraft manufacturer, is due in one year. Since the order is invoiced in Euros, American Air is concerned that volatility in the USD/Euro exchange rate over the next one year could significantly affect the US dollar cost of the ordered aircrafts. To deal with the foreign exchange risk resulting from this transaction, American Air has several alternatives.

1) It can choose not to hedge and bear the resulting foreign exchange risk.

2) It can use a forward contract to fully or partially hedge foreign exchange risk.

3) It can use euro currency options to fully or partially hedge foreign exchange risk.

4) It can use a money market hedge to fully or partially hedge foreign exchange risk.

The spot exchange rate on December 15, 2018 is $1.244/Euro.

European call options expiring in one year, with Euros as the underlying asset, trade on a major exchange. The price for these call options with a strike price of $1.24/Euro is $0.027/Euro. The Euro options contract size is 10,000 Euros. American Air has a credit rating of Baa3 from Moodys Corp and BBB from S&P. US treasury bonds maturing in one year are yielding 0.68% and German government bonds (denominated in euros) maturing in one year are yielding 0.52%. The one-year $-Euro forward rate is $1.248/Euro. American Air can borrow for one year in Euros at 6.45% and in USD at 6.82%.

After weighing all the alternatives, make a recommendation to American Airs board of directors on how to manage its foreign exchange risk.

Guidelines:

To develop future potential scenarios, assume a range of $0.95/Euros to $1.45/Euros for the spot exchange rate in 1 year. For calculation and charting purposes in excel, use increments of $0.01/Euro in the exchange rate.

1. Evaluate the unhedged alternative. Compute and chart the US $ cost to American Air for potential spot exchange rates in one year.

2. Evaluate hedging using forward contracts. Compute and chart the US $ cost to American Air for potential spot exchange rates in one year using a 100% hedge and 50% hedge.

3. Evaluate hedging using call option contracts. Compute and chart the US $ cost to American Air for potential spot exchange rates in one year using a 100% hedge and 50% hedge.

4. Evaluate hedging using a money market hedge. Compute and chart the US $ cost to American Air for potential spot exchange rates in one year using a 100% hedge and 50% hedge.