Hedging Payables

General Motors considers hedging its payable of 500000 due in 3 months. It can obtain a forward contract to purchase Euro in 3 months. The forward rate of Euro for the same period is $1.2, the same rate as currency futures contracts on Euros.

As a second alternative, General Motors can use the money market to hedge its payable. The spot rate of Euro is $1.15 today. Moreover, the European money market interest rate is 5% for 3 months while the money market interest rate for the same period is 6% in the USA.

As a third alternative, the company can hedge its payable with a currency option. A suitable option with an exercise price of $1.24, a premium of $0.03, and an expiration date of 3 months from now is available. Assume that GMs forecasts for the spot rate of the Euro at the time payable is due are as follows:

• $1.20 (20% probability)
• $1.23 (30% probability)
• $1.26 (30% probability)
• $1.28 (20% probability)

Finally, the company may apply a strategy for hedging its payable which are known as wait-and-see. Thus, they can choose to sit idle and do nothing i.e., employing the Non-hedge alternatives, as well. Based on the above information regarding hedging alternatives:

a. Determine the value of hedging under different hedging alternatives. [2 + 3 + 5 = 10 Marks]

b. How much the company is paying under wait-and-see strategy? [1 Marks]

c. What is the real cost of hedging under different hedging alternatives? [2 Marks]

d. Which hedging alternative should be exercised? Explain why? [2 Marks]