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Chapter 8

Q. 8.MSE.12

Tennessee Co. purchases imports that have a price of 400,000 Singapore dollars, and it has to pay for the imports in 90 days. It will use a 90-day forward contract to cover its payables. Assume that interest rate parity exists and will continue to exist. This morning, the spot rate of the Singapore dollar was $.50. At noon, the Federal Reserve reduced U.S. interest rates. There was no change in the Singapore interest rates. The Singapore dollar’s spot rate remained at $.50 throughout the day. But the Fed’s actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next 3 months.

a. If Tennessee Co. locked in a 90-day forward contract this afternoon, would its total  U.S. dollar cash outflows be more than, less than, or the same as the total U.S. dollar cash outflows if it had locked in a 90-day forward contract this morning? Briefly explain.

b. Assume that Tennessee uses a currency options contract to hedge rather than a forward contract. If Tennessee Co. purchased a currency call option contract at the money on Singapore dollars this afternoon, would its total U.S. dollar cash outflows be more than, less than, or the same as the total U.S. dollar cash outflows if it had purchased a currency call option contract at the money this morning? Briefly explain.

c. Assume that the U.S. and Singapore interest rates were the same as of this morning. Also assume that the international Fisher effect holds. If Tennessee Co. purchased a currency call option contract at the money this morning to hedge its exposure, would  you expect that its total U.S. dollar cash outflows would be more than, less than, or the same as the total U.S. dollar cash outflows if it had negotiated a forward contract this morning? Briefly explain.

Step-by-Step

Verified Solution

a. Less than because the discount would be more pronounced or the forward premium would be reduced.
b. More than because the option premium increased due to more uncertainty.
c. More than because there is an option premium on the option and the forward rate has no premium in this example, and the expectation is that the future spot rate will be no higher than today’s forward rate. The option is at the money so exercise price is same as expected spot rate but you have to pay the option premium.