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## Q. 21.FSE.7

Assume that Jarret Co. (a U.S. firm) expects to receive 1 million euros in one year. The existing spot rate of the euro is \$1.20. The one-year forward rate of the euro is \$1.21. Jarret expects the spot rate of the euro to be \$1.22 in one year.
Assume that one-year put options on euros are available, with an exercise price of \$1.23 and a premium of \$.04 per unit. Assume the following money market rates:

 United States Euro Zone Deposit rate 8% 5% Borrowing rate 9% 6%

a. Determine the dollar cash flows to be received if Jarret uses a money market hedge. (Assume Jarret does not have any cash on hand when answering this question.)
b. Determine the dollar cash flows to be received if Jarret uses a put option hedge.

## Verified Solution

a. Money market hedge:
Borrow euros:
1,000,000/(1.06) = 943,396 euros to be borrowed
Convert the euros to dollars:
943,396 euros × \$1.20 = \$1,132,075
Invest the dollars:
\$1,132,075 × (1.08) = \$1,222,641

b. Put option: Pay premium of
\$.04 × 1,000,000 = \$40,000
If spot rate in one year = \$1.22 as expected, then the put option would be exercised at the strike price of \$1.23. The cash flows would be
1,000,000 × (1.23 – \$.04 premium) = \$1,190,000
Thus, the money market hedge would be most appropriate.