AJ Industries (AJI), a Frederick, MD based firm, has just signed a contract to purchase a piece of very sophisticated chip making equipment from Li Van Weaver, Ltd. (LVW), an Austrian firm based in Salzburg, for €1,250,000. The sale was made in May 2016 with payment due six months later. Because this is a sizable contract for AJI and because the contract is in EUR rather than USD, CFO of AJI is considering several hedging alternatives to reduce the exchange rate risk arising from the purchase and hired you as a consultant. To help the CFO make a hedging decision you have gathered the following information.
The spot exchange rate is $0.8924/€
The six month forward rate is $0.8750/€
AJI’s cost of capital is 8%
The Euro zone 6-month borrowing rate is 6%
The Euro zone 6-month lending rate is 4%
The U.S. 6-month borrowing rate is 3%
The U.S. 6-month lending rate is 1%
November 2013 put options for €625,000: strike price $0.9000, premium is 1.5%? November 2013 call options for €625,000: strike price $0.9000, premium is 1.0%
1-What type of exposure is AJI facing? How much?
2-If AJI carries out a forward hedge, how much dollars will they need to fulfill this contract in November 2016?
3-Explain how AJI might carry out a money market hedge. (Hint: Just explain each step of the money market hedge – no need to do any calculations.)
4-What is the dollar value of this contract if AJI chooses a money market hedge?
5-CFO would like to consider a hedging strategy using F/X options. Evaluate the outcome of an options hedge. Draw the payoff function for this option hedge.