Oregon Transportation Inc. (OTI) has just signed a contract to purchase light ra

ID: 2754613 • Letter: O

Question

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

from a manufacturer in Germany for euro 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

What is the cost of a call option hedge for OTI's euro receivable contract? (Note:

Calculate the cost in present value dollars.)

A. $52,500

B. $55,380

C. $56.125

D. $58,275

Cost of Call option = Premium price + Interest on amount borrowed for premium

Premium = 1.42*1.5% *2500000 = $53250

Interest on 53250 for 6 months at 8% = 53250*4/100 = 2130

Total cost of call option hedge in $ = 53250 + 2130 = 55380(This would be payable in six months)

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