Case study

Gulf Manufacturing has just signed a contract to sell agricultural equipment to Bosch, a German firm, for 1,250,000. The sale was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, Gulf 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.

The spot exchange rate is $1.1740/

The six-month forward rate is $1.1480/

The Gulfs cost of capital is 12% per year.

The Eurozone 6-month borrowing rate is 7% per annum (or 3.5% for 6 months)

The Eurozone 6-month lending rate is 5% per annum (or 2.5% for 6 months)

The U.S. 6-month borrowing rate is 6% per annum (or 3% for 6 months)

The U.S. 6-month lending rate is 4.5% per annum (or 2.25% for 6 months)

December put options for 625,000; strike price $1.18, the premium price is 1.5%

Gulfs forecast for 6-month spot rates is $1.19/

The budget rate, or the lowest acceptable sales price for this project, is $1,425,000 or $1.14/

If Gulf chooses to hedge its transaction exposure in the forward market, the company will __________ 1,250,000 forward at a rate of ___________.

(a) sell; $1.1740/

(b) sell; $0.8924/

(c) buy; $1.1740/

(d) buy; $0.8924/

Answer:

Gulf chooses to hedge its transaction exposure in the forward market at the available forward rate. The payoff in 6 months will be __________.

(a) $1,467,500

(b) $1,125,000

(c) $1,435,000

(d) $1,425,000

Answer:

If Gulf locks in the forward hedge at $.8750/, and the spot rate when the transaction was recorded on the books was $1.174/, this will result in a foreign exchange loss accounting transaction of _____________.

(a) $0

(b) $32,500

(c) This was not a loss; it was a gain of $32,500.

(d) There is not enough information to answer this question.

Answer:

Gulf would be ____________ by an amount equal to ____________ with a forward hedge than if they had not hedged and their predicted exchange rate for 6 months had been correct.

(a) better off; $52,500

(b) better off; $10,000

(c) worse off; $52,500

(d) worse off; $10,000

Answer:

Gulf could hedge the Euro receivables in the money market. Using the information provided, how much would the money market hedge return in six months assuming that Gulf reinvests the proceeds at the U.S. investment rate?

(a) $1,250,000

(b) $1,449,777

(c) $1,460,411

(d) $1,502,947

Answer:

Money market hedges almost always return more than forward hedges because of the greater risk involved.

(a) True

(b) False

Answer:

A _________ hedge allows Gulf to enjoy the benefits of a favorable change in exchange rates for their Euro receivables contract while protecting the firm from unfavorable exchange rate changes.

(a) forward

(b) call option

(c) put option

(d) money market

Answer:

What is the cost of a put option hedge for Gulfs Euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firms cost of capital as the appropriate interest rate for calculating future values.)

(a) $23,333

(b) $22,013

(c) 23,333

(d) 22,013

Answer:

The cost of a call option to Gulf would be ____________.

(a) $23,333

(b) $22,013

(c) $24,265

(d) There is not enough information to answer this question.

Answer: