Paper

International Corporate Finance, MGMT S-2710

POBLEM SET 3, Due 5:00 pm July 27, 2012

Solution

1. You are the treasurer of Arizona Corporation and must decide how to hedge (if at all) future receivables of 350,000 Australian dollars (AUD) 180 days from now. Put options are available for a premium of $.025 per unit and an exercise price of $1.055 per Australian dollar. Call options are available for a premium of $0.035 and an exercise price of $1.055. The forecasted spot rate of the Australian dollar in 180 days is:

Future Spot Rate | Probability |

$1.050 | 20% |

$1.054 | 20% |

$ 1.055 | 15% |

$1.058 | 45% |

The 90-day forward rate of the Australian dollar is AUD/USD 1.0545/54

(a) What option strategy can Arizona use to hedge its receivables?

Answer: Buy a put option

(b) What is the probability that the option will be exercised (assuming Arizona purchased it)?

Answer: 55%, because there is a 45% probability that the spot rate will be higher than the put exercise price.

(c) What will be the net receivables if the option is exercised?

Answer: If the put is exercised, you will receive $1.055 per AUD minus the premium of $0.025 per AUD. Thus a net of $1.030 per AUD will be received for the 350000 AUD, netting 360,500 USD.

Receivables with the options hedge = 0.55 x 1.03 x 350000 + 0.45 x 35000 x 1.033 = $360,972.50

(d) Is the option strategy better than a forward contract?

Answer: Total received with ‘sell-forward’ hedge = 350000 x 1.0545 = USD 369,075, which is higher than that with the options hedge, so forward hedge is better.

(e) Would leaving the receivables un-hedged have been better than the hedging strategies?

(15 points total)

Answer: If left un-hedged, average rate for AUD will be $1.05515, thus total receivable =

350000 x 1.05515 = $369,302.50 which is higher than the forward; however under the forward contract, amount received has no standard deviation, whereas standard deviation of...