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Today is November 30, 2021. As the newest hire for BOA, you must advise a client on the costs and benefits of hedging a transaction.

Today is November 30, 2021. As the newest hire for BOA, you must advise a client on the costs and benefits of hedging a transaction. Your client is scheduled to receive a payment of 7,250,000 on November 30, 2022, 1-year from today. Financial information is as follows.

  • U.S. interest rate is 5% per year
  • euro interest rate is 3% per year
  • Spot rate: S($/)=1.1075
  • year forward rate: F12($/)=1.1255
  • Call option: $1.13/; premium is 1.2/
  • Put option: $1.13/; premium is 1.5/.

(a) Describe the type of risk exposure that your client is facing.

(b) If your client would like to hedge with a 1-year forward contract. What is the USD value of the receivable in 1-year? Describe the costs and benefits of a forward contract hedge.

(c) Perform a money market hedge for your client to hedge the risk. How much will your client receive in USD with a money market hedge? (Show the transactions in a transaction table. List clearly each transaction and cash flow with currency symbol and cash flow sign.)

(d) Describe the costs and benefits of an option contract hedge. What kind of option contract should you recommend to your client (call or put)? What is the minimum dollar revenue your client will receive in 1-year with an option hedge?

(e) In a graph, draw the forward hedge, money market hedge and option market hedge lines. Indicate clearly on the graph all relevant exchange rates and dollar values of the hedging strategies.

(f) Assume that the chief BOA foreign exchange analyst forecasted that the euro exchange rate should be traded between $1.145/ and $1.155/. Among the forward hedge, money market hedge, and option hedge, which hedging strategy would you suggest to your client? Why? Show the breakeven exchange rate between hedging strategies. Justify your answer with quantitative and qualitative reasons for full credit.

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