1. Your US-based firm is about to sign a contract to buy a machine from a manufa
ID: 2756234 • Letter: 1
Question
1. Your US-based firm is about to sign a contract to buy a machine from a manufacturer based in Singapore. The price of the machine is S$ 3,000,000 and the payment is to be made in US$ after one year (at t = 1) according to the following rule. If the spot rate at t = 1 (e1) is between $0.68/S$ and $0.72/S$, the payment in US$ is to be computed using e1. If e1 is less than $0.68/S$, the payment in US$ is to be computed using $0.68/S$. If e1 is greater than $0.72/S$, the payment in US$ is to be computed using $0.72/S$.
(i) Show in a table form the end of period cash flows (in US$) for e1 ranging from $0.66/S$ to $0.74/S$.
(please explain US cash flows I already know what they are)
(ii) Alternatively, suppose that your firm makes the payment in S$ by buying S$ in the spot market at t = 1, that is, must pay S$ 3,000,000 to the Singapore firm. Show the option portfolio that you could hold to ensure that you have the same end-of-period US$ cash flows as those from the rule in the contract.
Explanation / Answer
1) Explanation:
The price of the machine is given in Singapore Dollars - S$ 3,000,000; but the payment is to be made in USD at the end of 1 year.
The problem gives the possible rates at which this conversion from S$ to USD will take place. (Otherwise it would depend on the prevailing spot rate after 1 year). It is related to the spot rates prevailaing in the market at the end of the year. It is given for a range of the future spot price.
As per the terms, the ultimate rate will vary between 0.68 and 0.72. Such a clause seeks to give protection to both the parties.
If the rate goes beyond 0.72, only 0.72 need be paid. It affords protection to the buyer in US.
If the rate goes below 0.68, payment has to be made at 0.68. This affords protection to the seller in S$.
This is evident from the following table:
End of period cash flows for e1 = 0.66 to 0.74 are given in table below:
2)
From 0.68 to 0.72 no strategy is required as the call option can lapse, and the required S$ bought at the spot rates, which is the rate at which it is to be paid.
For future spot rates of 0.66 and 0.67, the rates payable are 0.68. Here, the firm can buy S$ at lower prices and stands to gain. No option is required for this.
Possible Values of e1 Rate US$ Cash $ for !S$ applicable flows 0.66 0.68 2040000 0.67 0.68 2040000 0.68 0.68 2040000 0.69 0.69 2070000 0.70 0.70 2100000 0.71 0.71 2130000 0.72 0.72 2160000 0.73 0.72 2160000 0.74 0.72 2160000Related Questions
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