ABC Inc. (OTI) has just signed a contract to equipment to a manufacturer in Germany €2,500,000. The sell 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, OTI 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 $.8924/€-27
To find 6 months forward rate you call banks and they have access to euro zoon 6 moths interest rate of 6.5% -8.5% pa and the US 6 months interest rate of 5.5% -7.5%
OTI's cost of capital is 11%
The Euro zone 6-month money market rates are 7%-9% pa
The U.S. 6-month money market rates are 6%- 8% pa
The premium (option price) for December call options with strike price $.90 is 1.5%
The budget rate, or the highest acceptable purchase price for this project, is $2,175,000 or $.87/€
The December future contact has future price $ 0.895/euro when the contract is signed and he future will expire in 6 months. Each future contract for euro has Euro € 125,000 underline and the initial margin is $ 2,565, we ignore all cash statements during 6 months and assume everything happens when ht future expires. OTI plans to entire the short position of hedge the EURO receivable.
[There is also the tunnel forward (zero cost range option) strategic ABC can peruse of a PUT OPTION at strike price $ 0.87 and sale of a call option at a strike price of $0.92.
Answer:
Hints: there are following hedge tools available in this question: Forward, Money Market Hedge, option, future and tunnel future]