Oregon Transportation Inc. (OTI) just signed a contract to purchase light rail c

Question

Oregon Transportation Inc. (OTI) just signed a contract to purchase light rail cars from a manufacturer in Germany or 2,500.000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, OTI is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. The spot exchange rate is $1.40/euro The six month forward rate is $1.38/euro OTI's cost of capital is 11% The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) The U.S. 6-month lending rate is 6% (or 3% for 6 months) December call options for euro 625,000; strike price $1.42, premium price is 1.5% OTI's forecast for 6-month spot rates is $1.43/euro The budget rate, or the highest acceptable purchase price for this project, is $3,625,000 or $1.45/euro Refer to the data above. If OTI chooses NOT to hedge their euro payable, the amount they pay in six months will be $3,500, 000 $3,450, 000 3,450, 000 unknown today Refer lo data above. If OTI chooses to hedge its transaction exposure in the forward market, it will euro 2,500, 000 forward at a rate of buy; $1.38. buy; $1.40. sell; $1.38. sell; 1.40.

Explanation / Answer

1). If OTI choses not to hedge their amount payable , the amount they pay in six months would be Cost to light rail car in Germany 2,500,000 € Spot rate in Euro is $1.40 Per Euro 6 months forward rate $1.38 Per Euro OTI forecasted 6 months Spot rate in Euro $1.43 Per Euro If no hedging is done amount payable cost * 6 months spot rate ( 2500000 * 1.43) $3,575,000 However this is forcasted amount payable basis forcasted six months rate, which can change as well Ans D - Unknown 2). 6 months forward rate $1.38 Per Euro Cost to light rail car in Germany 2,500,000 € It will buy Euro at 6 months forward rate today ie 1.38$ / euro Ans A.

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