American Airlines has just signed a contract to purchase an A340-600 aircraft fr

Question

American Airlines has just signed a contract to purchase an A340-600 aircraft from Airbus for 250,000,000 euros. The payment is due six months later. As the Lead Risk Analyst of American Airlines, you are considering how best to hedge the exchange rate risk arising from the purchase, and need to make a recommendation to the Treasurer based on your analysis. You have gathered the following information:
The spot exchange rate is $1.2000/€
The six month forward rate is $1.1950/€
The cost of capital of American Airlines is 12% per annum.
The premium on a six-month call option on the euro with strike price $1.2000 is 2%.
You are trying to help decide between the following two alternatives:
Hedging with a forward contract...
Hedging using a call option on the euro...

a) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Justify your recommendation. (No calculations are necessary.) (5 points)

Answer:

b) Suppose that you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Justify your recommendation (No calculations are necessary.) (5 points)

Answer:

c) Suppose that you expect the euro to depreciate. By how much does the euro need to depreciate in order to make the call option a better alternative than the forward contract? In other words, how low does the euro have to go in value to make total cash outflow under the call option be less than that under the forward contract? Support your answer with calculations. (5 points)

Answer:

Please follow instructions carefully, I have been having a very hard time getting this problem answered for some reason. Please and thank you !!!!!!!!!!!

Explanation / Answer

In this case we have given

Payment due after six month is 250000000 Euro.

We have two alternatives

1) Forward: Which result in cash outflow of $298750000 i.e (250000000x1.1950)

2) Call Option: Suppose unfavorable condition(Euro price appreciate more than 1.2000$/Euro) after six month then cash outflow would be = $306000000 (i.e 250000000x1.2000+premium)

Now lets see these situations

Situation A)

Where strongly expect that euro to be appreciate: That means we need to pay more for acquiring euro if not hedged, and since forward rate is already lower than spot rate and call option then it is pertinent to go for forward contract.

Situation B)

Strongly expect that euro will depreciate :

case 1) If Spot price after six month is greater and equal to forward rate then we should go for forward contract.Because cash outflow will less in forward contract

case 2) If Spot price after six month is less than forward contract then benefit arise in call option only when its recover its premium.

For better understanding lets see Situation C

Situation C:

Lets first find the rate where forward and call option shall have same cash outflow:-

As we know that cash outflow in case of forward contract = $298750000

That means $298750000 = 250000000Euro x Rate + 6000000(i.e commission)

Solving that we find Rate = 1.171$/Euro

If Euro depreciate and comes under 1.171 then call option would be better

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