Reference no: EM131965853
An importer in the US, a NYC jewelry store, places an order in February 2018 for German-made watches. Delivery will take place in three months (May 2018), and the invoice is payable upon delivery. The order is invoiced in Euros (EUR) for the amount of €2,000,000, and the current spot rate is $1.0875/€. (Note: You don’t need to consider the “opportunity cost” or future value for the cost of options in this problem.)
a. At the current spot rate, what would the order cost the importer in US dollars?
b. In a full and complete essay, explain exactly what specific currency risk (transaction exposure) this importer faces. That is, explain and answer the question: What is the imported is worried about and why? (Note: No calculations are required for this part, and you don’t need to consider any information below or any specific risk management strategies.)
May 2018 EUR currency call options are available for 2.0¢/€ or $0.02/€, with an exercise price of $1.12/€. One EUR option contract is for €62,500.
c. How many EUR call options should the jewelry store purchase to hedge the entire amount of EUR, and what will the cost be per contract, and what will the total cost be for all of the call options?
d. Show a fully and completely labeled profit/loss payoff diagram for the importer’s call option (show his/her position only, not both sides).
e. Separately, for each of the four possible May 2018 spot rates below, calculate: i) the gain or loss on the call options, ii) the cost to buy the Euros at the spot rate, iii) the net total dollar cost of the order that includes the cost of buying the Euros at the spot rate, and the profit or loss on the options contracts, and iv) the net cost per EUR ($/EUR) for the order (Total Dollar Cost / €2,000,000). Show work for each four ex-rates separately, do not combine. NOTE: The importer will buy the €2,000,000 at the spot ex-rate, and settle the call options with cash for a profit or loss.
S ($/€) = $1.2200/EUR (show and label parts i, ii, iii, iv for this ex-rate)
S ($/€) = $1.1800/EUR (show and label parts i, ii, iii, iv for this ex-rate)
S ($/€) = $1.10000/EUR (show and label parts i, ii, iii, iv for this ex-rate)
S ($/€) = $1.0500/EUR (show and label parts i, ii, iii, iv for this ex-rate)
f. Referring specifically to your numerical answers above, write a full essay of at least one full paragraph that summarizes the main conclusions about how this importer can use call options to hedge currency risk. Imagine that you are a risk management specialist and explaining this strategy to the watch buyer, who is your client.
g. Using your answers to Problems #1 above and #2 (this problem), discuss any differences you notice between using currency options to hedge currency risk and currency futures contracts to hedge currency risk. (You can ignore transactions costs for this question, e.g. commissions, fees, premiums, etc.)