Reference no: EM133116937
Congratulations! You have been hired by a consulting company to work as a junior financial consultant. Your new responsibilities include assessing clients' financial situations, developing financial plans to help clients achieve their long-term and short-term financial goals, explaining the pros and cons of various investment strategies, and answering all finance-related questions, and addressing clients' concerns.
Your boss asks you for assistance with a new client, an Italian company Incantieri, which manufactures cruise ships.
Incantieri sold a cruise ship to Disney Cruise Line, a U.S. company, and billed $1 billion payable in six months. It is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.15/€ and six-month forward exchange rate is $1.21/€ at the moment. Incantieri can buy a six-month put option on U.S. dollars with a strike price of €0.85/$ for a premium of €0.02 per U.S. dollar. Currently, the six-month interest rate is 2% in the euro zone and 2.5% in the U.S
1. Compute the guaranteed euro proceeds from the American sale if Incantieri decides to hedge using a forward contract.
2. If Incantieri decides to hedge using money market instruments, what action does Incantieri need to take? What would be the guaranteed euro proceeds from the American sale in this case?
3. If Incantieri decides to hedge using put options on U.S. dollars, what would be the 'expected' euro proceeds from the American sale? Assume that Incantieri regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.
4. Which method of hedging would you recommend to Incantieri in order to control the exchange risk? Think about its pros and cons.