Fin 535 answer
32. Comparison of Techniques for Hedging Receivables.
a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one‑year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows:
Future Spot Rate Probability $.61 20% .63 50 .67 30
Assume that one‑year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One‑year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore Deposit rate 8% 5% Borrowing rate 9 6
Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position.
ANSWER:
Forward hedge Sell S$500,000 × $.62 = $310,000
Money market hedge 1. Borrow S$471,698 (S$500,000/1.06 = S$471,698) 2. Convert S$471,698 to $283,019 (at $.60 per S$) 3. Invest the $283,019 at 8% to earn $305,660 by the end of the year
Put option hedge (Exercise price = $.63; premium = $.04)
Possible Spot Rate
Option Premium per Unit
Exercise
Amount Received per Unit (also accounting for premium)
Total Amount Received for S$500,000
Probability
$.61
$.04
Yes
$.59
$295,000
20%
$.63
$.04
Yes or No
$.59
$295,000
50%
$.67
$.04
No
$.63
$315,000
30%
The forward hedge is superior to the money market hedge and has a 70% chance of outperforming the put option hedge. Therefore, the forward hedge is the optimal hedge. Unhedged Strategy
Possible Spot Rate
Total Amount Received for S$500,000
Probability
$.61
a. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one‑year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows:
Future Spot Rate Probability $.61 20% .63 50 .67 30
Assume that one‑year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One‑year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore Deposit rate 8% 5% Borrowing rate 9 6
Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position.
ANSWER:
Forward hedge Sell S$500,000 × $.62 = $310,000
Money market hedge 1. Borrow S$471,698 (S$500,000/1.06 = S$471,698) 2. Convert S$471,698 to $283,019 (at $.60 per S$) 3. Invest the $283,019 at 8% to earn $305,660 by the end of the year
Put option hedge (Exercise price = $.63; premium = $.04)
Possible Spot Rate
Option Premium per Unit
Exercise
Amount Received per Unit (also accounting for premium)
Total Amount Received for S$500,000
Probability
$.61
$.04
Yes
$.59
$295,000
20%
$.63
$.04
Yes or No
$.59
$295,000
50%
$.67
$.04
No
$.63
$315,000
30%
The forward hedge is superior to the money market hedge and has a 70% chance of outperforming the put option hedge. Therefore, the forward hedge is the optimal hedge. Unhedged Strategy
Possible Spot Rate
Total Amount Received for S$500,000
Probability
$.61