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Calculate the expected cost

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Problem 1: Oregon Transportation Inc. (OTI) has just signed a contract to purchase light rail cars from a manufacturer in Germany €2,500,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, OTI is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information:

  • The spot exchange rate is $.8924/€
  • The six month forward rate is $.8750/€
  • OTI's cost of capital is 11%
  • The Euro zone 6-month money market rates are 7%-9% pa
  • The U.S. 6-month money market rates are 6%- 8% pa
  • The premium (option price) for December call options with strike price $.90 is 1.5%
  • OTI's forecast for 6-month spot rates is $.91/€
  • The budget rate, or the highest acceptable purchase price for this project, is $2,300,000 or $.92/€

Assume that analysts consider the following likely future spot exchange rate scenarios each with an equal probability of occurance (i.e. 33.3%)(Hint: Use statistical expectation to calculate the expected cost)

Strong Dollar: $0.8600 
Neutral :$0.8750
Weak Dollar :$0.9500

Assume that Oregon selected to use December call option.What will be the expected cost of the rail cars?

$2,237,500

$2,204,035

$2,160,527

$2,270,965

$2,283,750

None of the above

Reference no: EM13842564

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