What is the risk associated with that strategy

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Reference no: EM131223549

Group Project: jetBlue

You work as an analyst for jetBlue (US) treasury division. The airliner had purchased an Airbus A340-600 passenger jet from Airbus for €245,890,000and the contract was signed yesterday. The decision to purchase a wide body jet with approximately 380 passengers in a typical seating layout reflects jetBlue's planned expansion into the growing Asian and the Gulf markets. Currently, Emirates is the only carrier with a Boston-Dubai non-stop service and the demand is strong where other airlines may soon apply for license to operate that route. jetBlue has received permission from Massport and other state and federal regulatory bodies to operate the route, despite its partner airline Etihad operating a JFK-Abu Dhabi non-stop service . The Airbus340-600, to be delivered in September 2016, will be used for the proposed jetBlue Boston-Dubai non-stop service starting October 2016.

The first of the four payments totaling €245,890,000is due in 1 year from now, with subsequent payments spread over the next three years. The CFO is concerned about the foreign exchange exposure of this upcoming payment, though the remaining payments will also need to be hedged very soon. The CFO's concerns are valid because the currency market has seen an increase in volatility since May 2014. For example, in August 2014, the Euro was trading at $1.3495. Especially during the last 12 months, the currency market volatility has been unprecedented, despite the almost zero interest rate policy in developed countries. The increase in volatility has been fueled mostly by the Eurozone instability, large scale interventions by major central banks, the removal of the ceiling on the Swiss franc , the capital flight from Russia due to Russian acquisition of Crimea, currency crisis in several Asian countries, the Chinese devaluation of the Yuan, and the outlook for a rate hike in the United States.

To set up the hedge, you looked at the Bloomberg screen for rates:

USD LIBOR 12-months .801% - .835%

Euro LIBOR 12-months .125% - .163%

The FX dealer at the State Street Bank in Boston offered the following spot rate and 12 months forward points:

Spot ($/€) $1.0960-62

12 months 93.56-95.37

The CFO provided her own forecasts of exchange rates (and her own probability distribution):

Forecasted Exchange Rate Rate probability

Spot ($/€) in 1-yr $1.1312-42 .6

$1.0901-12 .3

$1.0456-98 .1

You called the Bank of New York Mellon (BNYM) and asked for $1.13 strike OTC options. BNYM quoted the following OTC prices (European style and maturity date coincides with due date of the account payable):

Call Option on euro (exercise price) $1.13

Premium (per euro) $0.03644

Put Option on euro (exercise price) $1.13

Premium (per euro) $0.0629

Assignment: Develop a presentation to the CFO. Specifically, show the dollar value of the first payment under each hedging strategy and recommend the best hedging strategy? What is the risk associated with that strategy?

The possible hedging choices are:

a) Remain unhedged but position marked at

a. CFO's forecasted future spot rate, or

b. Assuming Interest Rate Parity.

b) Forward hedge.

c) Money market hedge (synthetic forward)

d) Option hedge. Premium is borrowed.

e) Use the Black-Scholes model to calculate the implied volatility. Furthermore, confirm if these premiums are correct and explain the logic of the steps you took to derive the premiums (call and put). In other words, what combinations of the given strike prices, maturity, volatility, spot bid/ask, and the USD LIBOR/Euro LIBOR rates would generate the call premium and most importantly, what is the approximate underlying hedging strategy the call option is based on? Explain the strategy. Repeat the same for the put option. Use the Black-Scholes model on Blackboard or https://www.ozforex.com.au/forex-tools/tools/fx-options-calculator.

f) The jetBlue CFO would also like a Zero net premium (ZNP) option hedge based on the BNYM quotations. The CFO also wanted to know what would be the impact on dollar value of the account payable if the spot turns out to be $1.16 on expiration. What is the risk of a ZNP hedge? What happens to the ZNP hedge if the Euro goes to a parity with the USD?

Deliverable: The following section headings are suggested:

Executive Summary
Introduction of the problem
Analysis of each hedging alternative
A comparison of the hedging alternatives with pros/cons
Recommendation.

Reference no: EM131223549

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