Hedging Decision Indiana Co. expects to receive 5 million euros in one year from exports, and it wants to consider hedging its exchange rate risk. The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Co. uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8 percent, versus an annual interest rate of 5 percent in the eurozone. Put options on euros are available with an exercise price of $1.11 an expiration date of one year from today, and a premium of $0.06 per unit. Estimate the dollar cash flows that Indiana Co. will receive as a result of using each of the following strategies: Unhedged strategy Money market hedge Call option hedge Which hedge is optimal?

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 11, Problem 40QA
Textbook Problem

Hedging Decision Indiana Co. expects to receive 5 million euros in one year from exports, and it wants to consider hedging its exchange rate risk. The spot rate of the euro as of today is $1.10. Interest rate parity exists. Indiana Co. uses the forward rate as a predictor of the future spot rate. The annual interest rate in the United States is 8 percent, versus an annual interest rate of 5 percent in the eurozone. Put options on euros are available with an exercise price of $1.11 an expiration date of one year from today, and a premium of $0.06 per unit. Estimate the dollar cash flows that Indiana Co. will receive as a result of using each of the following strategies:

  1. Unhedged strategy
  2. Money market hedge
  3. Call option hedge

Which hedge is optimal?

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