You are a U. S.-based importer of bicycles and just bought competition-style bicycles for €100,000 from Italy. You owe €100,000 to the Italian supplier in one year. You are concerned about the number of dollars you will have to pay for this purchase in one year. Suppose:
- The spot exchange rate is $1.50/€
- The forward exchange rate is $1.25/€
- U. S. interest rate is 3.00% per annum
- The interest rate in Europe is 4.00% per annum
- Call option with a strike price of $1.30/€ is available with premium of $0.10/€
- Put option with a strike price of $1.30/€ is available with premium of $0.20/€
Round your answers to two decimal places.
a. Unhedged position: Suppose you decide not to do anything. In one year, spot rate happens to be $1.50/€. What will be the total dollar cost of this purchase then? What will be the total dollar cost if spot rate happens to be $1.30/€ in one year? Or $1.40/€? Are you subject to exchange rate risk in this case?
b. Forward market hedge: How can you lock in the exact dollar cost of this purchase by using forward contracts? Should you agree to buy or sell €100,000 forward in one year’s time? What will be the total dollar cost of this purchase with forward hedge? Are you subject to exchange rate risk in this case?
c. Money market hedge: How can you hedge using money market hedge? Where should you borrow and how much? What is the total dollar cost of this purchase? Are you
subject to exchange rate risk in this case?
d. Option market hedge: How can you hedge using options? Should you purchase put or call options on euros? What is the total premium today? When will you exercise your options and what will be the total dollar cost if you exercise? And when will you not exercise your options and what will be the total dollar cost then?
e. Comparing hedging methods: What are the break-even exchange rates between hedging methods? When do you prefer which hedging method?