You are a U.S.-based importer of bicycles and just bought competition-style bicycles for 100,000 from Italy. You owe 100,000 to the Italian supplier in one year. You are concerned about the amount of dollars you will have to pay for this purchase in one year. Suppose:

• Spot exchange rate is $1.50 per euro
• Forward exchange rate is $1.25 per euro
• U.S. interest rate is 3.00% per annum
• Interest rate in Europe is 4.00% per annum

Call option with strike price of $1.30 per euro is available with premium of $0.10 per euro.

Put option with strike price of $1.30 per euro is available with premium of $0.20 per euro.

Required:

a-1. Unhedged position: Suppose you decide not to do anything. In one year, the spot rate happens to be $1.50 per euro. What will be the total dollar cost of this purchase then?

a-2. What will be the total dollar cost if the spot rate happens to be $1.30 per euro in one year?

a-3. What will be the total dollar cost if the spot rate happens to be $1.40 per euro in one year?

a-4. Are you subject to exchange rate risk in this case?

b-1. Forward market hedge: How can you lock in the exact dollar cost of this purchase by using forward contracts? Should you agree to buy or sell 100,000 forward in one years time?

b-2. What will be the total dollar cost of this purchase with the forward hedge?

b-3. Are you subject to exchange rate risk in this case?

c-1. Money market hedge: How can you hedge using money market hedge? Where should you borrow and how much?

c-2. What will be the total dollar cost of this purchase with money market hedge?

c-3. Are you subject to exchange rate risk in this case?

d-1. Option market hedge: How can you hedge using options? Should you purchase put or call options in euros?

d-2. What is the total premium today?

d-3. When will you exercise your options and what will be the total dollar cost if you exercise?

d-4. And when will you not exercise your options and what will be the total dollar cost then?

e-1. Comparing hedging methods: What are the break-even exchange rates between hedging methods?

e-2. When do you prefer which hedging method?