Reference no: EM132022039

1. Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. 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, CVT 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 $1.250/euro. The six month forward rate is $1.22/euro. CVT's cost of capital is 11%. The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months). The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months). The U.S. 6-month borrowing rate is 8% (or 4% for 6 months). The U.S. 6-month lending rate is 6% (or 3% for 6 months). December call options for euro 750,000; strike price $1.28, premium price is 1.5%. CVT's forecast for 6-month spot rates is $1.27/euro. The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro. CVT would be ________ by an amount equal to ________ with a forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had been correct.

a. worse off; $150,000

b. worse off; €150,000

c. better off; $150,000

d. better off; €150,000

2. The variability of a firm's operating cash flows is probably reduced by international diversification of its production, sourcing, and sales because exchange rate changes under disequilibrium conditions are likely to increase the firm's competitiveness in some markets while reducing it in others.

True

False