Suppose that your firm is a U.S.-based importer of German automobile accessories

Question

Suppose that your firm is a U.S.-based importer of German automobile accessories. You pay for them in euros and sell them in dollars. You have just ordered next year's inventory. In one year your firm owes a payment of €100,000 to your German supplier. Today's spot exchange rate is €1.00 = $1.20; the one-year forward rate is €1.00 = $1.15. How can you fix the dollar cost of this order? Select one: a. Since the spot price is more than the forward price, you should trade your dollars for euros today and pay your supplier early. b. Sell a call option on the euro with a one-year maturity. c. Enter into long position in the one-year euro futures contract at €1.00 = $1.15. This will fix the cost of €100,000 at $115,000. d. Enter into short position in the one-year euro futures contract at €1.00 = $1.15. This will fix the cost of €100,000 at $115,000.

Explanation / Answer

1.Answer (C) Enter into long position in the one year euro futures contract at euro 1 = $1.15.

Explanation : It was given that our American based firm used to make payments in Euros and receipts in dollars.

Since we just have ordered next year's inventory and our liability to pay German automobile accessories with in 1 year would be 100000 euros,and payment should be made in euros.So that we should make the payment by observing the exchange rate for make it profitable to the firm. Current exchange rate is 1 euro = $1.20 and the one year forward rate was 1 euro = $ 1.15,It seems to be dollar was strengthning in future so that we should enter in to a long position for euros in one year euro future contract,So that our obligation on the date of payment would be $115000 only.

If we make the payment at current exchange rate 1 euro = $1.20 ,The total payment would be $120000 ,so it is better to enter into forward contract so that we can save the firm $5000.Since we need euro we cannt sell a call option but we can buy it ,here you are payer not a receiver so it is not advisable to enter into short position.

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