Timing the Hedge
Response to the following problem:
Red River Co. (a U.S. firm) 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. This morning, the spot rate of the Singapore dollar was $.50. At noon, the Federal Reserve reduced U.S. interest rates, while there was no change in interest rates in Singapore. The Fed's actions immediately increased the degree of uncertainty surrounding the value of the Singapore dollar over the next 3 months. The Singapore dollar's spot rate remained at $.50 throughout the day. 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 Red River Co. purchased a currency call option contract at the money this morning to hedge its exposure, 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 negotiated a forward contract this morning? Explain.