Evaluate alternative hedging strategies, Financial Management

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Peak Inc. needs to order Canadian raw materials to use in its production process. The Canadian exporter typically invoices Peak in Canadian dollars. Assume that the current exchange rate for the Canadian dollar is $0.73/C$ and Peak needs C$100,000 in 90days. Two call options for Canadian dollars with expiration dates in three months and the following additional information are available:

 

Call option 1 premium on Canadian dollars =$0.015

Call option 2 premium on Canadian dollars =$0.008

Call option 1 strike price =$0.73

Call option 2 strike price =$0.75

One option contract represents C$50,000.

Peak can either (a) buy call options with the lower strike price, or (b) construct a bull strategy that involves buying the call option with the lower price and simultaneously writing the call option with the higher strike price. Further assume that sport exchange rate at the option expiration date is any of the following: $0.70, $0.73, $0.75, and $0.80.

Required:

a) Evaluate both hedging strategies relative to an unhedged position.

b) Repeat the exercise assuming that the spreader writes the option with the lower strike price and buys the option with the higher strike price. Note that it is the case of currency bear spread.                                                                       

# Assume that Fresno Corp. will need £200,000 in 180 days. It considers using (a) a forward hedge, (b) a money market hedge, (c) an option hedge, or (d) no hedge. Its analysts organize the following information in order to evaluate alternative strategies to hedge foreign exchange risk.

Spot rate of pound as of today = $1.50.

180-day forward rate of pound as of today = $1.47.

Interest rates are as follows:

 

U.K.

U.S.

180-day deposit rate

4.5%

4.5%

180-day borrowing rate

5.0%

5.0%

 

A call option on pounds that expires in 180 days has an exercise price of $1.48 and a premium of $0.03 per unit.

Another call option on British pound that expires in 180 days has an exercise price of $1.49 and a premium of $0.035 per unit.

A put option on pounds that expires in 180 days has an exercise price of $1.49 and a premium of $0.02 per unit.

Fresno Corp. forecasts the future spot rate in 180 days as follows:

Possible future spot rates

Probability

$1.43

20%

$1.46

20%

$1.52

30%

$1.55

30%

Required:

Estimate the expected dollar cost of paying for the payables under each alternative strategy and suggest the best strategy considering that Fresno Corp. is a risk-averse company.

# Assume that Fresno Corp. will need £200,000 in 180 days. It considers using (a) a forward hedge, (b) a money market hedge, (c) an option hedge involving buying a call option with lower strike price, or (d) another option hedge involving a bull spread. A currency bull spread is constructed by buying a call option for a particular underlying currency and simultaneously writing a call option for the same currency with a higher strike price. Its analysts organize the following information in order to evaluate alternative strategies to hedge foreign exchange risk.

Spot rate of pound as of today = $1.50.

180-day forward rate of pound as of today = $1.47.

Interest rates are as follows:

 

U.K.

U.S.

Deposit rate (annualized)

4.5%

4.5%

Borrowing rate (annualized)

5.0%

5.0%

A call option on pounds that expires in 180 days has an exercise price of $1.46 and a premium of $0.035 per unit.

Another call option on British pound that expires in 180 days has an exercise price of $1.49 and a premium of $0.025 per unit.

Fresno Corp. forecasts the future spot rate in 180 days as follows:

Possible future spot rates

Probability

$1.43

25%

$1.46

25%

$1.52

25%

$1.55

25%

 

Required: Evaluate alternative hedging strategies compared with the default case of no hedge alternative.

 

6. Assume that Fresno Corp. will need £200,000 in 180 days. It considers using (a) a forward hedge, (b) a money market hedge, (c) an option hedge involving buying call options with lower strike price, or (d) another option hedge involving a bull spread. A currency bull spread is constructed by buying a call option for a particular underlying currency and simultaneously writing a call option for the same currency with a higher strike price. Its analysts organize the following information in order to evaluate alternative strategies to hedge foreign exchange risk.

Spot rate of pound as of today = $1.50.

180-day forward rate of pound as of today = $1.47.

Interest rates are as follows:

 

U.K.

U.S.

Deposit rate (annualized)

5.5%

4.5%

Borrowing rate (annualized)

6.0%

5.0%

A call option on pounds that expires in 180 days has an exercise price of $1.46 and a premium of $0.035 per unit.

Another call option on British pound that expires in 180 days has an exercise price of $1.49 and a premium of $0.025 per unit.

Fresno Corp. forecasts the future spot rate in 180 days as follows:

Possible future spot rates

Probability

$1.35

10%

$1.43

10%

$1.46

30%

$1.52

20%

$1.55

20%

$1.60

10%

Required: Evaluate the alternative hedging strategies compared with the default case of no hedge alternative.


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