Question

TEK wishes to hedge a EUR4,000,000 account receivable arising from a sale to Olivetti (Italy). Payment from Olivetti is due in three months. TEK’s Italian unit does not have ready access to local currency borrowing, eliminating the money market hedge alternative. Citibank has offered TEK the following quotes:

Spot rate	USD1.2000/EUR
3 month forward rate	USD1.2180/EUR
Three month euro interest rate	4.2% per year
3 month put option on euros at strike price of USD1.0800/EUR	3.4%
TEK’s weighted average cost of capital	9.8%

What are the risks of each alternative?

Answer 1

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Answer:

1. Do nothing and exchange euros for dollars at end of 3 months Amount of euro receivable If spot rate in 3 months is the same as the forward rate US dollar proceeds of receivable would be € 4,000,000.00 1.2180 $4,872,000.00 Very uncertain Risky Amount of euro receivable If spot rate in 3 months is the same as the current spot rate US dollar proceeds of receivable would be € 4,000,000.00 1.2000 $4,800,000.00 Very uncertain; Risky 2. Sell euro receivable forward at the 3-month forward rate Amount of euro receivable forward rate US dollar proceeds of receivable would be € 4,000,000.00 1.2180 $4,872,000.00 Certain; Locked-in 3. Buy a put option on euros Amount of euro receivable Current spot rate ($/euro) Premium on put option, % Cost of put option (amount x spot rate x percent premium) € 4,000,000.00 1.2000 3.400% $163,200.00 If the spot rate at end of 3-months is less than strike rate the option is exercised yielding gross dollars of Less cost of option (Premium) plus US$ interest on premium Net proceeds of AR if option is exercised (this is Minimum) $4,800,000.00 (167,198.40) S4,632,801.60 Minimum is guaranteed; could be greater Summary of Alternatives Do Nothing Sell A/R forward Buy Put Option Value $4,800,000.00 $4,872,000.00 $4,632,801.60 Certainty? Risky Certain Minimum