Reference no: EM132142405

Question - Bridgestone, a Japanese-based company, receives recurring income in USD of about USD 5 billion per year. The current exchange rate is ¥120/USD. The annualized exchange rate volatility is 10%. The interest rates in Yen and USD are respectively 0.5% and 3.5%, leading to a 1 year forward price of ¥116.52/USD.

a) Calculate the 5% Cash-Flow-at-Risk associated with the first payment of USD 5 billion in 1 year from now.

b) Hedge next year's exposure using a simple forward contract (be clear on all terms of the contract.

c) The forward price is below the spot price. Explain both with a formula and intuitively why that must be the case. Use the evidence on ‘uncovered interest rate parity' to discuss whether the fact that the forward price is below the spot price implies that this hedge will be costly from the perspective of Bridgestone.

d) Hedge this exposure using a single option contract. Again, be clear on all terms of the contract. Assume an option premium equivalent to 5% of the notional.

e) Options are expensive. Adapt your position under question (d) so that the total hedging cost is reduced. Make sensible assumptions about the option premia of the (different) options involved.

f) Forward contracts are short-term hedging products; the recurring nature of these cash flows implies, however, that this is truly a long-term exposure. Propose 1 operational and 2 financial long-term hedging solutions. Be precise on how you would set up these financial hedges.