Problem 13

Intro

Great Lakes Water exports bottled water to Europe. The company expects to receive 2,000,000 euros () in one year from its exports.

The firm expects the following exchange rate scenarios and probabilities:

Scenario	Spot rate in one year	Probability
A	$1.09	0.3
B	$1.16	0.2
C	$1.23	0.5

The spot rate is $1.16 per euro and the one-year forward rate is $1.161 per euro. The U.S. interest rate is 5% and the euro interest rate is 11%.

A put option on euros expiring in one year costs $0.008 per euro and has an exercise price of $1.16 per euro.

Attempt 1/10 for 10 pts.

Part 1

What is the expected dollar cash flow in one year if the company does not hedge its receivables (in $)?

Correct

Scenario	Spot rate in 1 year	Probability	Dollar cash flow
A	$1.09	0.3	$2,180,000
B	$1.16	0.2	$2,320,000
C	$1.23	0.5	$2,460,000

Expected cash flow = 0.3 * $2,180,000 + 0.2 * $2,320,000 + 0.5 * $2,460,000

= $2,348,000

Attempt 1/10 for 10 pts.

Part 2

What will be the cash inflow if the firm uses a forward contract (in $)?

Correct

Cash inflow in $ = Receivables x Forward rate

= 2,000,000 * $1.161/

= $2,322,000

Attempt 1/10 for 10 pts.

Part 3

What is the value of the receivables in one year with a money market hedge (in $)?

Correct

With a money market hedge, the firm borrows euros, converts them to dollars and then invests the dollars in short-term securities (money market instruments). It uses its euro receivables to pay off the loan.

Euros to be received in one year (future value):

FV=2,000,000FV=2,000,000

Euros borrowed now (present value):

PV=FV1+r=2,000,0001+0.11=1,801,802PV=FV1+r=2,000,0001+0.11=1,801,802

Dollars received from converting euros now:

PV$=PV SPV$=PV S

= 1,801,802$1.16/1,801,802$1.16/

= $2,090,090$2,090,090

Value of dollar investment after one year (future value):

FV$=PV$(1+r$)FV$=PV$(1+r$)

= $2,090,090(1+0.05)$2,090,090(1+0.05)

= $2,194,595

Attempt 2/10 for 9 pts.

Part 4

What is the expected value of the receivables in one year with the put option hedge (in $)?

Submit.........

Attempt 1/5 for 10 pts.

Part 5

What is the optimal strategy for the company?

Money market hedge

Forward contract

No hedging

Put options

Correct

Since the put option hedge results in the largest dollar cash flow, it is the optimal strategy for the firm.

Attempt 3/10 for 9 pts.

Part 6

If the exchange rate turns out to be $1.3 per euro in one year, what was the cost of hedging (in $)?

Submit-----------