Chicago Co. expects to receive 5 million euros in 1 year from exports. It can use any one of the following strategies to deal with the exchange rate risk. Estimate the dollar cash flows received as a result of using the following strategies:
a. Unhedged strategy
b. Money market hedge
c. Option hedge
The spot rate of the euro as of today is $1.10. Interest rate parity exists. Chicago uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8 percent versus an annual interest rate of 5 percent in the euro zone. Put options on euros are available with an exercise price of $1.11, an expiration date of 1 year from today, and a premium of $.06 per unit. Estimate the dollar cash flows it will receive as a result of using each strategy. Which hedge is optimal?
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