Detail the hedging strategy with options

Reference no: EM131071154

Question 1. A German company is exporting some equipment to the United States and will receive payment of US$1 million three months from now. The current spot exchange rate is $1.25/€. The treasurer of the company expects the dollar to depreciate in the next few weeks, and is concerned about it. The three-month forward rate is $1.28/€.

(a) Given the treasurer's expectation, what action can he take using the forward contract?

(b) Three months later, the spot exchange rate turns out to be $1.30/€. Did the company benefit because of the treasurer's action?

Question 2. The Singapore dollar-U.S. dollar (S$/$) spot exchange rate is S$1.60/$, the Canadian dollar-U.S. dollar (CD/$) spot rate is CD1.33/$ and the S$/CD spot exchange rate is 1.15. Assume you have $1,000,000 with which to conduct the arbitrage. Show how you can make a triangular arbitrage profit by trading at these prices. Please list your strategies and determine the triangular arbitrage profit. (Ignore bid-ask spreads for this problem.)

Question 3. An investor believes that the price of a stock, say IBM's shares, will increase in the next 60 days. If the investor is correct, which combination of the following investment strategies will show a profit in all the choices? List all investment strategies that will generate positive returns and explain why.

(i) - buy the stock and hold it for 60 days
(ii) - buy a put option
(iii) - sell (write) a call option
(iv) - buy a call option
(v) - sell (write) a put option
a) (i), (ii), and (iii) b) (i), (ii), and (iv) c) (i), (iv), and (v) d) (ii) and (iii) Answer: c)

Question 4. A U.S. company has issued floating-rate notes with a maturity of 10 years, an interest rate of (6-month LIBOR+0.15%), and total face value of $10 million. The company now believes that interest rates will rise and wishes to protect itself against this by entering into an interest rate swap. A dealer provides a quote on a 10-year swap whereby the company will pay a fixed rate 4 percent and receive (6-month LIBOR-0.10%). Interest is paid semiannually. Assume the current LIBOR rate is 3%. Indicate how the company can use a swap to convert the debt to a fixed rate. Calculate the first net payment and indicate which party makes the payment. Also, what is the dealer's first net payment (or profit)? Assume that all payments are semiannual and made on the basis of 180/360.

Question 5. An article fromThe Economist provides the following data: Big Mac is priced at $2.71 in the United States, while it is sold at 262 yens in Japan. The actual dollar exchange rate on the same date is 120 yen/dollar.

(a) The implied PPP is the exchange rate that would give the Big Mac the equivalent price in both currencies. What is the PPP of the dollar implied by the price of Big Mac in Japan?
(b) By which percent is the yen undervalued relative to dollar, according to the actual exchange rate and the implied PPP exchange rate?

Question 6. Suppose that on Jan. 1, GE was awarded a contract to supply turbine blades to Luthansa. On Dec. 31, GE would receive payment of Euro10 million for these blades. The money market interest rates and foreign exchange rates are given as follows:

U.S. interest rate 10% per annum

Euro interest rate 15% per annum

Spot exchange rate $1/Euro

Forward exchange rate $0.957/Euro (one-year maturity)

(a) Explain the strategy and calculate the hedged value of GE's cash flow using a forwardmarket hedge.
(b) Explain the strategy and calculate the hedged value of GE's cash flow using a moneymarket hedge.

Question 7. Today's settlement price on a Chicago Mercantile Exchange (CME) Yen futures contract is $0.8011/¥100. Your margin account currently has a balance of $2,000. The next three days' settlement prices are $0.8057/¥100, $0.7996/¥100, and $0.7985/¥100. (The contractual size of one CME Yen contract is ¥12,500,000). You have a short position in one futures contract.

(a) Calculate the changes in the margin account from daily marking-to-market and the balance of the margin account after the third day.

Rationale: $2,325 = $2,000 +¥12,500,000×
[(0.008011- 0.008057) + (0.008057- 0.007996) + (0.007996- 0.007985)]

Please note that $0.8011/¥
100 = $0.008011/¥
and $0.8057/¥
100 = $0.008057/¥
, etc

(b) Do the problem again assuming you have a long position in the futures contract.

Rationale: $1,675 = $2,000 + ¥12,500,000×[(0.008057 - 0.008011)+ (0.007996 - 0.008057)
+ (0.007985 - 0.007996)]

Please note that $0.8011/¥
100 = $0.008011/¥
and $0.8057/¥
100 = $0.008057/¥
, etc.

Question 8. A U.S. multinational, Hoola Hoopa, Inc., hired a Canadian IT consulting firm to upgrade its international network. In 6 months when the contract is over, Hoola Hoopa will need 1.5 million Canadian dollars to pay the consultants. The company needs to decide whether or not it should enter into a forward contract to hedge its exchange rate risk. Fill in the answers below using the US$ Equivalent rates listed in the table below.

Country U.S. $ Equivalent
Mon Fri
Canada (Dollar) 0.6879 0.6879
1-month forward 0.6868 0.6869
3-months forward 0.6844 0.6845
6-months forward 0.6803 0.6804

(a) The most recent Canadian dollar spot rate is ______________________

(b) Canadian dollar 6-mo forward rate on Monday is ______________________

(d) What it would cost Hoola Hoopa if it hedged with a forward contract to buy 1.5 million Canadian dollars 6 months later?

(e) Compare the cost of the forward contract, or the hedged position, with the cost of buying the Canadian dollars on the spot market in 6 months. Fill in the table below to show the cost of buying CD$1.5 million at different spot rates, and then calculate Hoola Hoopa's potential gains or losses from hedging with a forward contract.

Spot Rate in 6 months	Unhedged Position	Hedged Position	Potential Gains/losses in US$ from Hedge
0.6700
0.6803
0.6900

Question 9. Suppose the spot ask exchange rate, Sa($/£), is $1.46 = £1.00 and the spot bid exchange rate, Sb($/£), is $1.45 = £1.00. If you were to buy $10,000,000 worth of British pounds and then sell them five minutes later, how much of your $10,000,000 would be "eaten" by the bid-ask spread?

Question 10. A Japanese EXPORTER has a €1,000,000 receivable due in one year.

Listed Options

Strike

Puts

Calls

Euro

€62,500

$1.25 = €1.00

$0.0085 per €

$0.02 per €

Yen

¥12,500,000

$1.00 = ¥100

$0.0085 per ¥100

$0.02 per ¥100

(a) Detail the hedging strategy with options.

(b) Estimate the cost today of an options strategy that will eliminate exchange rate risk.

Reference no: EM131071154

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