Risk management
1. You are the finance director of CR7, a US based manufacturer of luxury products. The CEO has just signed a large contract with ‘Hotel de Paris’ from Monaco for a large delivery of accessories, worth € 1 million. Both delivery and payment are due in 7 months from now. At the current exchange rate of about 1.25 $ per €, this contract is worth about $ 1.25 million.
A: Next the cash flow (in $) of CR7 as a function of the $/€ exchange rate will be given. Based on a long position in € (unhedged).
$/€
Cash Flow
0.75
$ 750.000
1
$ 1.000.000
1.25
$ 1.250.000
1.50
$ 1.500.000
1.75
$ 1.750.000
B: Below the arbitrage-free 7-month forward price is calculated, also is shown the currency forward contract via replicating.
CR7 is located in the US therefore, the company has two options: 1) the company can deposit their money on US saving account with a 1,75% interest rate for a duration of 7 months. 2) The other option for the firm is to buy Euros on the spot market for 0,58% on European account (also for a duration of 7 months). After the period of 7 months it can exchange euros for dollars. This exchange is against the 7 month forward rate. The exchange is arbitrage-free therefore, both options one and two should gain the same yield. Consequently, to gain the same yield the 7-month forward rate needs to be equal to 1,264669.
$
Currency
Annual %
7-month %
Expected Value
EUR
1%
0,58%
80,46803
US
3%
1,75%
101,7654
US/EUR
1,264669
€
Currency
Annual %
7-month %
Expected Value
EUR
1%
0,58%
100,5850
US
3%
1,75%
127,2067
US/EUR
1,264668
C: The graphically position of the forward in the case of fully eliminating exchange rate risk.
The company CR7 expects a depreciation of the euro therefore, CR7 should take a short position in euros. The spot price of the euro can fluctuate, thereby there margin account in US dollars will gain or lose 1,75% over the period (7-months).
A: Next the cash flow (in $) of CR7 as a function of the $/€ exchange rate will be given. Based on a long position in € (unhedged).
$/€
Cash Flow
0.75
$ 750.000
1
$ 1.000.000
1.25
$ 1.250.000
1.50
$ 1.500.000
1.75
$ 1.750.000
B: Below the arbitrage-free 7-month forward price is calculated, also is shown the currency forward contract via replicating.
CR7 is located in the US therefore, the company has two options: 1) the company can deposit their money on US saving account with a 1,75% interest rate for a duration of 7 months. 2) The other option for the firm is to buy Euros on the spot market for 0,58% on European account (also for a duration of 7 months). After the period of 7 months it can exchange euros for dollars. This exchange is against the 7 month forward rate. The exchange is arbitrage-free therefore, both options one and two should gain the same yield. Consequently, to gain the same yield the 7-month forward rate needs to be equal to 1,264669.
$
Currency
Annual %
7-month %
Expected Value
EUR
1%
0,58%
80,46803
US
3%
1,75%
101,7654
US/EUR
1,264669
€
Currency
Annual %
7-month %
Expected Value
EUR
1%
0,58%
100,5850
US
3%
1,75%
127,2067
US/EUR
1,264668
C: The graphically position of the forward in the case of fully eliminating exchange rate risk.
The company CR7 expects a depreciation of the euro therefore, CR7 should take a short position in euros. The spot price of the euro can fluctuate, thereby there margin account in US dollars will gain or lose 1,75% over the period (7-months).