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Chapter 21

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.

Step-by-Step

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.