Problem 9.8 Aquatech Aquatech is a U.S.-based company which manufactures, sells, and installs water purification equipment. On April 11th the company sold a system to the City of Nagasaki, Japan, for installation in Nagasaki's famous Glover Gardens (where Puccini's Madame Butterfly waited for the return of Lt. Pinkerton.) The sale was priced in yen at 20,000,000, with payment due in three months. Spot exchange rate: One-month forward rate: Three-month forward: One-year forward: 118.255/$ (closing mid-rates) 117.760/$, a 5.04% p.a. premium 116.830/$, a 4.88% p.a. premium 112.450/$, a 5.16% p.a. premium Money Rates One month Three months Twelve months United States 4.8750% 4.9375% 5.1875% Japan 0.09375% 0.09375% 0.31250% Differential 4.78125% 4.84375% 4.87500% Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot 118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from 118.30/$ to X117.550/$. Additional information: Aquatech's Japanese competitors are currently borrowing yen from Japanese banks at a spread of 2 percentage points above the Japanese money rate. Aquatech's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable. Three-month options from Kyushu Bank: * Call option on 20,000,000 at exercise price of 118.00/$: a 1% premium. * Put option on W20,000,000, at exercise price of 118.00/$: a 3% premium. a) What are the costs and benefits of alternative hedges? Which would you recommend, and why? b) What is the breakeven reinvestment rate when comparing forward and money market alternatives