Question

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Part III Case Analysis (20 Marks) Assume that a Euro Zone MNC expects to receive CHF 35 million in one (1) year. The existing spot rate of the CHF is EURO.79 - CHFI. The one (1) year forward rate of the CHF EURO 80 - CHF The MNC has calculated a probability distribution for the future spotle in one (1) year as follows: future spot rate probability EURO.7960 25% EURO.8400 48% EUR0.9300 27% Assume that one (1) year put options on CHF are available, with an exercise price of EURO.84 CHF1 and a premium of EURO.08 per unit. One (1) year call options on CHF are available with an exercise price of EURO.79- CHF1 and a premium of EURO.06 per unit. Assume the following annual money market rates : Euro Zone Switzerland deposit rate borrowing rate 1.75% 2.60% 1.0% 2.0% Required: (a) Given this information, determine (calculate) whether a forward hedge, money market hedge, or, a currency options hedge would be the most appropriate" for the MNC. [15 Marks] (b) Then compare the above "most appropriate" hedge to an unhedged strategy and decide whether the Euro Zone MNC should hedge its receivables position. [5 Marks

Answer 1

Answer to question (a)

1.Euro Zone MNC expects to receive CHF35 million in one year from now and wants to hedge currency fluctuation risk.

2.The best strategy of hedging will be the one where the MNC can maximize EURO receivable by converting CHF. Now we will evaluate each strategy one by one

i) FORWARD HEDGE

One year forward rate is EURO0.8 = 1CHF

Therefore, if the MNC enters into one year forward contract to sell 35 million CHF, EURO receivable will be

35x0.8 million = 28 million.

ii) MONEY MARKET HEDGE

Since we have 35 million CHF receivable at the end of 1 year,we will borrow 34.3137 million CHF (35 million/1.02) today @ 2% and convert it into EURO at spot rate of EURO 0.79=1 CHF And deposit it @ 1.75 %.

Therefore Euro receivable at the end of 1st year will be 27.5822 million (34.3137x.79x1.0175).

iii) CURRENCY OPTION HEDGE

We will buy put option which gives us a right to sell CHF at the excercise price of EURO 0.84=1 CHF at the cost of EURO 0.08= 1CHF

Therefore EURO receivable by excercising the option will be 29.4 million (35x0.84)

Cost of buying the option 35 million x 0.08 = 2.8 million

NET EURO receivable = 29.4-2.8 = 26.6 million

Since under the forward contract we receive the highest Euro of 28 million , its is better to use forward contract for hedging.

Answer to Question (b)

If do not hedge our foreign currency exposure then decide to sell CHF spot based on spot rate prevailing on the day we receive 35 million chf ,Our EURO receivable will be = Expected spot rate based on probability¹ x 35million

= 0.8533 x 35 million
= 29.8655 million

¹Calculation of Expected Spot Rate

( 0.7960 x 25% + 0.84 x 48% + 0.93 x 27% ) = EURO 0.8533 for 1 CHF

if we do not hedge our expected euro recievable will be 29.8655 million which is higher as compared to 28 million when we Hedge, therefore we may not Hedge our Currency risk.