Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. The purchase 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, CVT 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 $1.250/euro

The six month forward rate is $1.22/euro

CVT's cost of capital is 11%

The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)

The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)

The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)

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

December call options for euro 750,000; strike price $1.28, premium price is 1.5%

CVT's forecast for 6-month spot rates is $1.27/euro

The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro

1. Refer to Instruction 10.1. If CVT chooses NOT to hedge their euro payable, the amount they pay in six months will be:

		$3,500,000
		$3,900,000
		3,000,000
		unknown today