Howard University Comparison

Comparison of Techniques for Hedging Receivables.

Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one‑year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows:

Future Spot Rate Probability

$.58 20%

.63 50

.67 30

Assume that one‑year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One‑year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates:

U.S. Singapore

Deposit rate 7% 4%

Borrowing rate 8 5

Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position.

ANSWER:

Forward hedge

Money market hedge

Option hedge

Possible Spot Rate

Option Premium per Unit

Exercise

Yes or

No?

Amount Received per Unit (also accounting for premium)

Total Amount Received for S$500,000

Probability

Unhedged Strategy

Possible Spot Rate

Total Amount Received for S$500,000

Probability

  1. Assume that Baton Rouge, Inc. expects to need S$1 million in one year. Using any relevant information in part (a) of this question, determine whether a forward hedge, a money market hedge, or a currency options hedge would be most appropriate. Then, compare the most appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its payables position.

ANSWER:

Forward hedge

Money market hedge

Option hedge

Amount Paid Total

Option per Unit Amount

Possible Premium Exercise (including Paid for

Spot Rate per Unit Option? the premium) S$1,000,000 Probability

Unhedged Strategy

Possible Total

Spot Rate Amount Paid Probability

Question 2

a -Compare and contrast the various exchange hedging strategies. Create a table for the comparison. Ensure to give the advantages and disadvantages of each strategy.

b. Explain how a forward contract can backfire. Illustrate using numbers not used in the text or covered in class.

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