CAN YOU EXPLAIN ME THE SOLUTION PLEASE, WHERE THE CALCULATIONS IN THE SOLUTIONS COME FROM?

Question $1$

Assume you are an importer in Turkey. You have imported washing and cleaning preparations worth of $$300,000.$ Your payment to the US firm $($in US dollar$)$ is due in three months.

Three month maturity TRY interest rate is $17\%($annual$)$ and same maturity USD interest rate is $0\mathrm{.}25\%($annual$).$ For simplicity assume that the borrowing and lending interest rates are the same. Spot exchange rate is $7\mathrm{.}08$TL$/$US$ and three$-$month forward exchange rate is $7\mathrm{.}36$TL$/$US$ in the foreign exchange market. The company is cash rich and in case of excess need for cash the company gives up interest income rather than borrowing.

There are also currency options available in the financial market.

$$ Exercise price of a call option with a maturity of $3$ months is $7\mathrm{.}40$TL per US$$.$ The call premium is $0\mathrm{.}1121$TL per US$$.$

$$ Exercise price of a put option with a maturity of $3$ months is $7\mathrm{.}40$TL per US$$.$ The put premium is $0\mathrm{.}2623$TL per US$$.$

What can you do in order to hedge this exchange rate exposure so that you can redenominate this three$-$month payable into a Turkish Lira denominated payable with three$-$month maturity?

Describe your possible strategies to hedge this transaction exposure. Please show your computations and pick the best strategy under the given financial conditions above. If possible draw a chart, showing possible outcomes of your transaction exposure strategies under different levels of exchange rate possibilities in three months.

Answer $1$

$300\mathrm{.}000$USD Payable owed to be paid in $3$ months. TRY interest rate is $17\%$ and USD interest rate is $0\mathrm{.}25\%.$ Spot Rate is $7\mathrm{.}08$TRY$/$USD and $3$ mo forward rate is $7\mathrm{.}36$TL$/$US$$.$

Relative hedging instrument is the call option. Strike is $7\mathrm{.}40$TL per USD and premium is $0\mathrm{.}1121$TL per USD.

$1)$ Remain unhedged $($Uncertain outcome$)$

The greater the depreciation the higher will be your payable. Worse for your exposure.

$2)$ Buy your $$300$K payable forward.

$300,000$ x $7\mathrm{.}36=2,208,000$TRY cost will be fixed$/$guaranteed $3$ months later

$3)$ Money Market Hedge

Need to buy PV$(300,000$USD$)=300,000/(1+,0025/4)=299,812\mathrm{.}62$ USD

Costs $2,122,672$TRY at spot $7\mathrm{.}08$TRY$/$USD today.

Will cost $2,212,887$TRY in $3$ months @$17\%$ annual interest in $3$ months.

$4)$ Option Hedge

Buy call options for $300,000$ USD.

Premium is $0\mathrm{.}1121$ TRY per USD. Total premium paid today for $$300$K is $33,630$TRY.

Equivalent cost in $3$mos is $35,059$TRY$=33,630*(1+0,17/4)$

When exchange rate is greater than $7,40,$ the call option will be exercised at strike price $7,40$TRY$/$USD and $$300$K payable will cost $2,220,000$TRY, which will be the maximum cost for the payable. If the exchange rate will be lower than the strike price, then the option will not be exercised and instead the $$300$K will be purchased at the spot market which is cheaper. Hence the maximum cost will be $2,220,000+35,059$TRY$=2,255,059$TRY.

Option Hedge$=$Forward Hedge

$7,2431*300,000+35,059$TRY$=2,208,000$TRY

$7,2431$ is the exchange rate when the importer is indifferent between a forward hedge and option hedge.

$7,2594*300,000+35,059$TRY$=2,212,887$TRY

$7,2594$ is the exchange rate when the importer is indifferent between a money market hedge and option hedge.

Forward hedge costs less than money market hedge. Hence forward hedge dominates money market hedge.