Red Creek Industrial of Nashville TN purchased automated machinery from Hamburg Manufacturing of Germany for €5,000,000 with payment due in 6 months. The forecasting department of the firm expects the spot rate in six months to be $1.0620/€ The following quotes are available:
Six month investment interest rate on US$ 3.20% per annum
Loan rate on US$ 7.00% per annum
Six month investment interest rate on € 4.20% per annum
Loan rate on € 8.05% per annum
Spot exchange rate Bid $1.0660/€ Ask $1.0665/€
Six month forward rate Bid $1.0614/€ Ask $1.0622/€
Six month call option on €5,000,000 atan exercise price of $1.0700/€ and a 1.75% of spot ask premium.
RC’s cost of capital is 14% and it wishes to minimize the dollar cost of this payable. The CFO has informed your department that the company is currently in a low cash position and if a money market hedge is used, a U.S. dollar loan would be necessary.However, the option premium should be carried forward at the cost of capital.
1. (3 points) What is the cost using the forward market hedge?
2. (9 points) What is the cost using the money market hedge?
3. (8 points) What is the maximum cost of the option hedge? (Remember: include the FV premium and the exercise value).
4. (6 points) At what ending spot rate would the forward market hedge equal the call option hedge?
5. (2 points) Based on the forecast of 1.0620, which technique of the 3 above has the projected cheapest cost?
6. (2 points) If the spot rate ended up at 1.03, which technique would have had the cheapest cost?