Question

Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry for 500 million yen payable in one year. The current spot rate is ¥124/$ and the one-year forward rate is 110¥/$. The annual interest rate is in Japan is 5% for lending and 6% for borrowing; and in the United States it is 7% for lending and 8% for borrowing. The WACC is 7%. PCC can also buy a one-year call option on yen at the strike price of $0.0081 per yen for a premium of 0.00014$/¥.

a. Compute the future dollar costs of meeting this obligation using a forward hedge.

b. Compute the future dollar costs of meeting this obligation using a money market hedge. Explain step by step using both numbers and a written explanation the money market strategy.

c. Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.

Answer 1

a)	Option 1 -forward rate hedge
	The firm will sell forward contract @ yen 110/$
	Proceeds after 1 year			=	500m/110
				=	$4.545454 millions
	Option 2 -money market hedge
		Relevant interest rate (USA)			=	8%
		Relevant interest rate (JAPAN)			=	5%
	Step 1	The firm will borrow PV of yen 500 millions todays borrowing (500/1.05)*(1/124)=$3.840246 millions
	Step 2	PV of yen 500 million(500m/1.05=476.19 million yen) will be invested @ 5%
	Step 3	After 1 year,firm will pay $3.840246 with interest @ 8%,paying $4.147465 millions
	Step 4	The amount PV of yen500 million borrowed & invested will become yen 500 m in one year &settle the liabilty
	Money paid after one year				=	$4.147465 millions
	Option 3-option hedging strike price $0.0081/yen
		Option premium			=	$0.00014/yen
		Total option premium			=	500 million*0.00014
					=	$0.07 million
		Add: oppurtunity cost on premium			=	0.07million*1.07
					=	$0.0049 milions
		Spot rate after one year			=	yen 110/$ or $0.009091/yen(1/110=0.009091)
		benefit from option			=	(0.909091-0.0081)*500m
					=	$0.495455 millions
		Net benefit from option			=	benefit - premium-oppurtunity cost
					=	0.495455-0.07-0.0049
					=	$0.420555 millions
		Cash payment after 1 year			=	500m/110
					=	$4.545455 millions
		Less:option premium			=	-$0.420555 millions
			Net payment		=	$4.1249 millions
	There may be liitle difference due to decimal places
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