Answer All Questions 1. The Dole Company (USA) has just purchased a Canadian foo

Question

Answer All Questions 1. The Dole Company (USA) has just purchased a Canadian food distributor for C$6,000,000. Payment is due in six months. Dole's cost of capital is 12%. The following quotes are current in the market. Interest rate for borrowing Interest rate for investing Spot exchange rate Six-month forward exchange rate Six-month call option on C$6,000,000 at an exercise price of C$1.20/$, premium of 1% 6.00% pa. in USA 4.00% p.a. in USA $1.00 $1.00- 10.0% pa. in Canada 8.0% pa. in Canada C$1.20 C$1.22 Six-month put option on C$6,000,000 at an exercise price of C$1.20/$, premium of 2% a. Calculate the alternative ways that Dole can hedge the foreign exchange transaction exposure. b. At what spot rate in six months, option is better than forward hedge?

Explanation / Answer

a) FORWARD CONTRACT: Amount payable under the forward contract = 6000000/1.22 = $      49,18,032.79 CALL OPTION: Amount payable under the call option = 6000000/1.20 = $      50,00,000.00 Call premium = 5000000*1%, payable upfront = $            50,000.00 FV of call premium at COC of 12% for 6 months = 50000*12%/2 = $               3,000.00 Total cost under the call option $      50,53,000.00 MONEY MARKET HEDGE: Under the MMH, the firm should create a C$ asset which will be equal to C$6000000 at the end of 6 months. Steps to be taken on day 1: Amount to be deposited in C$ = 6000000/1.04 = 5769230.77 Amount to be borrowed in $ to get the required funds = 5769230.77/1.20 = $      48,07,692.31 Maturity value of the $ Loan at the end of 6 months = 4807692.31*1.03 = $      49,51,923.08 Steps to be taken on due date: Collect the C$6,000,000 from the deposit made and pay the amount due for the purchase, which is also C$6,000,000 Pay the $ loan which will then have a maturity value = $      49,51,923.08 (Cost under the MMH) OF THE THREE ALTERNATIVES THE FORWARD CONTRACT OFFERS THE LEAST COST ALTERNATIVE. b) Amount payable under the forward hedge $      49,18,032.79 Less: FV of option premium $            53,000.00 Amount that can be paid to be equal to spot rate in 6 m $      48,65,032.79 Rate per C$ = 6000000/4865032.79 = $                  1.2333 Option is better if the spot rate is more than 1.2333C$/$.

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