A US company holds a volatile portfolio of European stocks which is expected to

Question

A US company holds a volatile portfolio of European stocks which is expected to be sold in one year with a proceed of e10 million. Current spot rate: sos/e $1.1000, Interest rate is 0.3% in US and 0.2% in Europe. You are asked to using the knowledge learned from FIN178 to hedge the currency risk for the company Please specify your action plans and their results. Forward: Please calculate the forward rate per the international parity condition and use forward to hedge the risk. Futures: Contract size 125,000 and one-year futures contract price is $ 1.0988e Option: one-year Euro FX Option (Euro/USD) Quotes: Exercise price: $1.1135/e, Call premium: $0.0148/ and Put premium: $ 0.0120/ Swap: Draw a roadmap to demonstrate your plan to convert such floating rate exposure to a fixed rate $ one. Possible actual spot rate SISV in one year: $1.0500/ and S1.1500/ respectively. Please specify the net position of each action plan (except swap) benchmarking against the current spot rate, and choose the best hedge tool for the company

Explanation / Answer

Given

The US company will receive € 10,000,000 after a year by selling its portfolio of stocks.

Spot rate = $1.1000/€

US (r) = 0.3%

Europe (r) = 0.2%

Option A :- Forward cover

As per International parity

F/S = US interest rate / Europe interest rate

F / 1.1000 = 1.003 / 1.002

1.002 * F = 1.1000 * 1.003

F = 1.1033 / 1.002

F = 1.1011

Forward rate = $ 1.1011/ €

Expeted spot rate = $1.0500 / €

Since expected spot rate is less than Forward rate

Profit on forward cover = ( 1.1011-1.0500) * 10,000,000

= $ 511,000

Therefore

inflow after one year = 1.1011 * 10,000,000 = $ 11,011,000

Option B:-

Step 1: Firm is afraid of € falling, therefore it should sell year end future.

Step 2: No. Of contracts = 10,00,000 / 125,000

= 8F- @ $ 1.0988 /€

Step 3 : square off future at 1.1500

Loss on squaring off = (1.1500-1.0988) *125,000*8

= $ 51,200

Step 4 : sell the Receivable €10,000,000 spot at $ 1.0500/ €

= 10,000,000* 1.0500 = 10,500,000

Final $ inflow = 10,500,000-51,200 = $10,448,800

Option 3: Option cover.

Since the firm has € Receivable after 1 year, it is afraid of € falling

Possibility 1:

step1 : buy put option at E= $ 1.1135/€

Future value of put premium (0.0120*10,000,000)* 1.003 = 120,360

If S = 1.0500, put exercise and therefore

Profit on maturity = 1.0500 [ (1.1135 - 1.0500)* 10,000,000)

= $ 635,000

Net pay off from put option = 514,640

Step 2 sell Receivable € 10,000,000 spot at 1.0500

= 10,000,000*1.0500 = 10,500,000

Step 2 : net $ inflow = 10,500,000 + 514,640

= 11,014,640

Possibility 2.

Step 1

Sell call option at E= 1.1135

Future value of call premium( 0.0148*10,000,000) * 1.003= 148,444

If S= 1.0500 call laps and there will be no pay off at the end of 1 year

Step 2 : sell Receivable € 10,000,000 spot at $ 1.0500/€

= 10,500,000

Step 3 :- net $ inflow after 1 year = 10,500,000+148,444

= 10,648,444

The best hedge tool for the company to sell put option at

E = $1.1135/€.

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