Question
Oregon Transportation Inc. (OTI) in U.S. has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 2,500,000. The
Oregon Transportation Inc. (OTI) in U.S. has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 2,500,000. The purchase was made in June with payment due 3 months later in September. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, OTI 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 $1.40/euro The 3-month forward rate is $1.38/euro OTI's cost of capital is 11% per annum The Euro zone 3-month borrowing rate is 2.5% The Euro zone 3-month lending rate is 1.8% The U.S. 3-month borrowing rate is 2% The U.S. 3-month lending rate is 1.5% September call options for euro 625,000; strike price $1.42, premium price is 1.5% OTI's forecast for 3-month spot rate is $1.43/euro The budget rate, or the highest acceptable purchase price for this project, is $3,625,000 or $1.45/euro In answering each of the following questions based on the information provided above, you must show your calculation and illustration diagram clearly: (a) If OTI chooses NOT to hedge their euro payable, the amount they pay at the end of 3 months will be ______. (5 marks) (b) If OTI chooses to hedge its transaction exposure in the forward market at the available forward rate, the required amount in dollars to pay off the accounts payable at the end of 3 months will be ________. (10 marks) (c) If OTI chooses to hedge its transaction exposure in the option market, (i) what is the cost of a call option hedge for OTI's euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm's cost of capital as the appropriate interest rate for calculating future values.) (5 marks) (ii) what are the possible payoffs at the end of 3 months? (15 marks) (d) Based on the above calculations, recommend to OTI the optimal hedging strategy and justify your choice your recommended. (5 marks)
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started