Main details about the Currency Hedge Case:
* John will buy 8,000 cases for € 1,030,000
* John will sell all 8,000 cases for $199 for each case ($ 1,592,000)
* Spot Exchange Rate is $1.32/ €
* The Forward rate for November is $1.37/ €
* The Forward rate for December is $1.39/ €
* Forward contracts can be bank forward rate of the month
* Future contract can be multiple of $ 62,500, expiring 3rd Friday of each month.
* November option can be multiple of $62,500 buying the $ 1.37/€ costing 3 cents per Euro.
* December option can be multiple of $62,500 buying the $ 1.39/€ costing 3 cents per Euro.
* Euro Interest per three months in annual rate 6%
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MONEY MARKET HEDGE
€ 1,030,000/ 1.06 = € 971,699 (1.06 discounted present value at 6% interest per 1 year)
When John borrows € 971,699 then he has to pay € 1,030,000 in 3 months.
Step 1: Borrow € 971,699
Step 2: Convert € 971,699 into $1,282,643 at current spot rate of 1.32/€
Step 3: Invest $1,282,643 in USA
Step 4: $1,282,643 (1.06) = $1,359,602 (1.06 discounted present value at 6.5% interest per year)
If this alternative would have given the same amount as Forward hedge the IRP condition would be approximately holding. In this case it is not, because results are different, and the Money Market Hedge dominates over the Forward hedge as the difference among the invested and the debt ($1,359,602-$1,282,643) will be 76,959 in gain. There will be no uncertainty in the exchange rate; however, the investment will be under risk for the role of the economy in the financial system.
Option premium price is 0.03 cent per Euro. Thus John pays $30,900 (0.03)(1,030,000) for the option. If the spot rate turns out to be $1.22/€ on the expiration date with the right to sell at $1.32, John will exercise its put option on the Euro to convert
November 1,030,000 (1.37) = 1,411,100
December 1,030,00(1.39) = 1,431,700
Considering the time value of money the total cost of the option would be