Plains States Manufacturing (a U.S. Corporation) has just signed a contract to sell agricultural equipment to Boschin, a German firm, for 2,000,000. Payment is due in six months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. Plains States' cost of capital is 13% per annum. The current spot rate is $1.18/ and the 6-month forward rate is $1.20/. The 6-month $ borrowing rate is 9% p.a. and the investing rate is 7% p.a. The 6-month borrowing rate is 6% p.a. and the investing rate is 4% p.a. The premium of the 6-month put option with a strike price of $1.18/ is $0.0005/. The premium of the 6-month call option with a strike price of $1.18/ is $0.0006/. The size of each option contract is 500,000. Plains States currently does not have any positive NPV projects available. It has an outstanding loan of $4,000,000. a. Show how Plains States can hedge the foreign exchange exposure in the money market. b. Show how Plains States can hedge the foreign exchange exposure in the forward market. c. What investing rate would make money market hedge and forward market hedge indifferent? Would you recommend a money market hedge or forward market hedge and why? d. Show how Plains States can hedge the foreign exchange exposure in the options market. Please make sure that you provide the total hedging cost. e. Can you directly compare an option market hedge to a forward market hedge? Why? Plains States Manufacturing (a U.S. Corporation) has just signed a contract to sell agricultural equipment to Boschin, a German firm, for 2,000,000. Payment is due in six months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. Plains States' cost of capital is 13% per annum. The current spot rate is $1.18/ and the 6-month forward rate is $1.20/. The 6-month $ borrowing rate is 9% p.a. and the investing rate is 7% p.a. The 6-month borrowing rate is 6% p.a. and the investing rate is 4% p.a. The premium of the 6-month put option with a strike price of $1.18/ is $0.0005/. The premium of the 6-month call option with a strike price of $1.18/ is $0.0006/. The size of each option contract is 500,000. Plains States currently does not have any positive NPV projects available. It has an outstanding loan of $4,000,000. a. Show how Plains States can hedge the foreign exchange exposure in the money market. b. Show how Plains States can hedge the foreign exchange exposure in the forward market. c. What investing rate would make money market hedge and forward market hedge indifferent? Would you recommend a money market hedge or forward market hedge and why? d. Show how Plains States can hedge the foreign exchange exposure in the options market. Please make sure that you provide the total hedging cost. e. Can you directly compare an option market hedge to a forward market hedge? Why
