Question

Kansas Corp., an American company, has a payment of €5.9 million due to Tuscany Corp. one year from today. At the prevailing spot rate of 0.90 €/$, this would cost Kansas $6,555,556, but Kansas faces the risk that the €/$ rate will fall in the coming year, so that it will end up paying a higher amount in dollar terms. To hedge this risk, Kansas has two possible strategies. Strategy 1 is to buy €5.9 million forward today at a one-year forward rate of 0.89 €/$. Strategy 2 is to pay a premium of $109,000 for a one-year call option on €5.9 million at an exchange rate of 0.88 €/$.

a. Suppose that in one year the spot exchange rate is 0.85 €/$. What would be Kansas’s net dollar cost for the payable under each strategy? (Round your answer to the nearest whole dollar amount.)

b. Suppose that in one year the spot exchange rate is 0.95 €/$. What would be Kansas’s net dollar cost for the payable under each strategy? (Round your answer to the nearest whole dollar amount.)

Answer 1

For forward contract, we have an obligation to exercise but for call option, we can check whether the call option rate is favourable when compared with spot rate and the decision is taken accordingly

	Euros	Spot Rate	USD today
Liablitiy for Kansan Corp	5,900,000	0.9	6,555,556
a. Suppose that in one year the spot exchange rate is 0.85 €/$.
Description	Euros	1 year Forward Rate	USD today	Actual Spot rate	Dollar using Spot rate after 1 year	Net Dollar cost
Strategy 1	5,900,000	0.89	6,629,213	0.85	6,941,176.47	6,629,213.48
Strategy 2	5,900,000	0.88	6,704,545	0.85	6,941,176.47
Option Premium			109,000
Total Liability in Dollars	5,900,000	0.87	6,813,545			6,813,545

In Stragery 1, the net dollar cost will be the forward rate

In Strategy 2, since the actual spot rate after 1 year is not favourable hence we will exercise the call option but we have to pay call option premium+agreed spot rate after 1 year. Hence the total cost will be the 1 year call option rate+option premium

b. Suppose that in one year the spot exchange rate is 0.95 €/$.
Description	Euros	1 year Forward Rate	USD today	Actual Spot rate	Dollar using Spot rate after 1 year	Net Dollar cost
Strategy 1	5,900,000	0.89	6,629,213	0.95	6,210,526.32	6,629,213.48
Strategy 2	5,900,000	0.88	6,704,545	0.95	6,210,526.32
Option Premium			109,000		109,000
Total Liability in Dollars	5,900,000		6,813,545	0.93	6,319,526.32	6,319,526.32

In Stragery 1, the net dollar cost will be the forward rate

In Strategy 2, since the actual spot rate after 1 year is favourable hence we will not exercise the call option but we have to pay call option premium. Hence the total cost will be the 1 year actual spot rate+option premium