Narto Co. (a U.S. firm) exports to Switzerland and expects to receive 500,000 Sw

Question

Narto Co. (a U.S. firm) exports to Switzerland and expects to receive 500,000 Swiss francs in one year. The one-year U.S. interest rate is 5% when investing funds and 7% when borrowing funds. The one-year Swiss interest rate is 9% when investing funds, and 10% when borrowing funds. The spot rate of the Swiss franc is $.80. Narto expects that the spot rate of the Swiss franc will be $.75 in one year. There is a put option available on Swiss francs with an exercise price of $.79 and a premium of $.02.

1. Determine the amount of dollars that Narto Co. will receive at the end of one year if it implements a money market hedge.

2. Determine the amount of dollars that Narto Co. expects to receive at the end of one year (after accounting for the option premium) if it implements a put option hedge.

Explanation / Answer

Money market hedge:

Borrow $, convert to Swiss Francs(SF), invest in Swiss Frans(SF), repay $ loan in one year.

Amount in Swiss Francs(SF) to be invested = SF 500,000/1.05= SF 476,190.50

Amount of $ needed to convert into SF = SF 476,190.5*spot rate = SF 476,190.5*$0.80 = $ 380,952.4

Interest and principal on $ loan after one year = $ 380,952.4*1.10 = $ 419,047.6

Put Option hedge:

Exercise price including premium = $0.79+$0.02 = $0.81

Sport rate after one year = $0.75

Therefore put option value = SF500,000*$0.81 = $405,000

Premium on put option = SF500,000*0.02*10% = $1,000

Amount expected to receive in put option hedge = $406,000.

From the above analysis, it is recommended to opt for put option hedging strategy.

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