A U.S. company has been asked to bid for a reconstruction project in post-war Iraq. Since its major foreign competitors are barred from bidding for Iraqi contracts by the US, the firm is pretty confident that it'll win the contract. It expects to receive €1,000,000 in one year. The firm has decided to hedge its exposure to the foreign exchange risk. It has gathered the following information:
Current spot exchange rate: $1.12/€
One-year forward rate: $1.10/€
Premium of call option (strike price = $1.10/€): $0.03/€
Premium of put option (strike price = $1.10/€): $0.03/€
Both the call and put will mature in one year.Ignore the interest cost on the option premium.
Please answer the following questions:
- If the firm uses a forward contract to hedge, how much in dollars will the firm receive from the sale of €1,000,000 one year from today?
- If the firm uses the option market to hedge, which option should the firm purchase? Please explain.
- Evaluate the result of the option hedge you choose in part 2. That is, how much in dollars will the firm receive from the sale of €1,000,000 one year from today? Please ignore the interest cost on the option premium.
- Incorporate the above two hedging alternatives into a diagram that represents the hedging result as a function of the future exchange rate. Calculate the breakeven point between the forward and option hedge.
- Which hedging alternative (forward hedge or option hedge) would you choose? Please explain.