Question

Suppose I own a French winery and that I am selling wine to the US in 90 days for a price of $ 100,000. The current spot price is $ 1.3 / €. We are going to use the option market to hedge against unfavorable exchange rate movements.

a. Considering this transaction only, what do we mean by 'unfavorable' exchange rate movements?

b. Suppose it costs me € 70,000 to produce and transport the wine, if the exchange rate in 90 days is the same as the current spot ($1.3/€), what is my profit in terms of euros? Suppose that there are options available that give me the option to exchange $ for € at an exchange rate of $1.4 per €. Suppose these options collectively cost you € 5000. We are going to consider two separate scenarios: Scenario #1: In 90 days, the spot exchange rate is $ 1.2/€. Scenario #2: In 90 days, the spot exchange rate is $ 1.5/€. Reminder: The options give you the right, not the obligation to exchange your $100,000 at $1.4 per €

. c. Given Scenario #1, what is your total profit / loss from selling the wine?

d. Given Scenario #2, what is your profit / loss from selling the wine?

e. Compare your answer in d) to your profit / loss if you, instead of hedging with options, went 'naked' as in not hedging at all (taking you chances in the spot market). Was it better to hedge or go naked? Assume Scenario #2.

f. How would your answer change in e) above if the spot rate was 1.6 $/€ (90 days from now) instead of the $ 1.5/€ as in scenario #2.

Answer 1

(a) Unfavorable exchange rate movement : In this case, out receivables are in Euro whereas our invoices are in dollars So, any increase in the exchange rate Euro per dollar would adversely affect our receivables. Any appreciation in Euro per dollar would lead to lesser receivables.

(b)

Amount in Dollars	100000
Current spot rate	1.3
Amount receivable in Euro	76923.07692
Cost	70000
Profit	6923.076923

(ii)

S.no	Particulars	Amount
	Amount in US dollars	100000
	Contracted Rate	1.4
	Receivable as per contracted rate	71428.5714
1	Premium	-5000
	Receivable as per spot rate	83333.3333
	Net receivable (spot exercised)	78333.3333
	Receivable if spot rate 1.3	76923.0769
C	Gain	1410.25641
2	Premium	-5000
	Receivable as per spot rate	66666.6667
	Premium paid	-5000
	Received amount as per contracted exercised	71428.5714
	Net Receivable	66428.5714
	Receivable if spot rate 1.3	76923.0769
D	Loss	(10,494.51)

E	It was better to go naked
	Loss(66428.57-66666.67)	(238.10)
F	Receivable as per spot rate 1.6	62500
	Gain	3928.57143