Question
On June 1st, Micca Metals sold a turbine to XXX Company of the Netherlands for 4,000,000, payable 2,000,000 on September 1st and 2,000,000 on December
On June 1st, Micca Metals sold a turbine to XXX Company of the Netherlands for 4,000,000, payable 2,000,000 on September 1st and 2,000,000 on December 1st. Micca Metals derived its price quote of 4,000,000 on May 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/.
By the time the order was received and booked on June 1st, the euro had strengthened to $1.1000/. Micca Metals had already gained an extra $80,000 from favorable exchange rate movements. Micca Metalss director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. Four approaches were possible:
1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/ and the 6-month forward quote was $1.1130/.
2. Hedge in the money market. Micca Metals could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum.
3. Hedge with foreign currency options. September put options were available at a strike price of $1.1000/ for a premium of 2.0% per contract, and December put options were available at $1.1000/ for a premium of 1.2%. September call options at $1.1000/ could be purchased for a premium of 3.0%, and December call options at $1.1000/ were available at a 2.6% premium.
4. Do nothing. Micca Metals could wait until the sales proceeds were received in September and December, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.
Micca Metals estimates the cost of equity capital to be 16% per annum. As a small firm, Micca Metals is unable to raise funds with long-term debt. U.S. T-bills yield 4% per annum. What should Micca Metals do?
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