Alternatives by reward and risk and choose the alternative

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Reference no: EM131870826

A computer software development company in the U.S. exports its software to the euro zone. The company’s European distributor asks and the company agrees to receive payments in euros (€). The distributor has just ordered a shipment that is priced in euros at today’s dollar equivalent of $36,044,800 for delivery and settlement in three months. The U.S.-based company is particularly worried about a high degree of uncertainty surrounding the euro exchange rate against the dollar. It decides to consider whether to hedge. Consulting with a NY bank, the company is advised that there are four different ways it can accomplish the hedge: Through a forward contract, a futures contract, an option contract, and through a money market hedge. The following information is available:

Spot $1.1264/€

3-month forward $1.1284/€

6-month forward $1.1360/€

3-month futures $1.1215/€

90-day call option #1 $ 1.1340/€ strike; $ 0.0030/€ premium

90-day put option #1 $ 1.1340/€ strike; $ 0.0050/€ premium

180-day call option #2 $ 1.1390/€ strike; $ 0.00820/€ premium

180-day put option #2 $ 1.1390/€ strike; $ 0.00980/€ premium

90-day dollar interest rate 6.40% per annum (deposit) 8.40% per annum (loan)

90-day euro interest rate 4.80% per annum (deposit) 5.80% per annum (loan)

1. Name the hedging instruments (from the above list) you should consider.

2. Show how each of these hedging alternatives can be achieved (explain and calculate).

3. Assume the following probability distribution for the euro spot rate at the end of three months. Analyze the option versus the no-hedge alternatives and decide which alternative is probably the better one of the two and why.

S₁ Probability

$1.1480/€ 30%

$1.1320/€ 40%

$1.0920/€ 30%

4. Compare all alternatives by reward and risk and choose the best alternative.

Reference no: EM131870826

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