Reference no: EM133068749

Problem:

Amazon Inc considers hedging its receivables of €200000 due in 3 months. It can obtain a forward contract to sell Euro in 3 months. The forward rate of Euro for the same period is $1.25, the same rate as currency futures contracts on Euros.

As a second alternative, Amazon Inc can use the money market to hedge its receivables. The spot rate of Euro is $1.18 today. Moreover, the European money market interest rate is 4.5% for 3 months while the money market interest rate for the same period is 5.5% in the USA.

As a third alternative, the company can hedge its receivables with a currency option. A suitable option with an exercise price of $1.25, a premium of $0.03, and an expiration date of 3 months from now is available. Assume that Amazon's forecasts for the spot rate of the Euro at the time receivable is due are as follows:

-$1.18 (30% probability)

-$1.23 (20% probability)

-$1.27 (30% probability)

-$1.30 (20% probability)

Finally, the company may apply a strategy for hedging its receivables which are known as wait-and-see. Thus, they can choose to sit idle and do nothing i.e., employing the Non-hedge alternatives, as well.

Based on the above information regarding hedging alternatives:

a. Determine the cash flow under different hedging alternatives.

b. How much the company should be receiving under the "wait-and-see" strategy?

c. What is the real cost of hedging under different hedging alternatives? Which hedging alternative should be exercised? Explain why?