American Airlines has just signed a contract (in April) to purchase an A340-600

Question

American Airlines has just signed a contract (in April) to purchase an A340-600 aircraft from Airbus for 250,000,000 euros. The payment is due six months later in October. As the Assistant Treasurer of this company, you are considering several hedging alternatives to reduce the exchange rate risk arising from the sale. Your financial analyst has gathered the following information:

The spot exchange rate is $1.1500/€

The six month forward rate is $1.1425/€

The cost of capital of American Airlines is 10% per annum.

The euro 6-month borrowing rate is 5% (or 2.5% for 6 months)

The euro 6-month lending rate is 3% (or 1.5% for 6 months)

The US dollar 6-month borrowing rate is 4% (or 2% for 6 months)

The US dollar 6-month lending rate is 2% (or 1% for 6 months)

The premium on October call options on the euro with strike price $1.1500 is 2%.

You would like to compute the total cost in dollars of each hedging alternative. Note that the phrase “total cost in dollars” refers to the total cash outflow in dollars when the payment is made in October.

a) Suppose that American Airlines chooses to hedge its transaction exposure using a forward contract. Will the firm sell or buy euros forward? What is the total cost in dollars (i.e., what will be the total cash outflow in dollars in October)? (10 points)

b) Suppose American Airlines chooses a money market hedge. What are the transactions that the firm will need to undertake to implement this hedge? State clearly which currency and what amount the company should borrow and what is the amount they would invest. What is the total cost in dollars using this hedge? (10 points)

c) Suppose American Airlines decides to hedge using a call option.

(i) Suppose that the spot rate in 6 months is $1.25 per euro. What will be the total cost in dollars for the firm after taking into account (the future value of) the cost of the option? (10 points)

(ii) Suppose that the spot rate in 6 months is $1.05 per euro. What will be the total cost in dollars for American Airlines after taking into account (the future value of) the cost of the option? (10 points)

d) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation (10 points)

e) Suppose that you expect the euro to depreciate. By how much does the euro need to depreciate in order to make the call option a better alternative than the forward contract? In other words, how low does the euro have to go in value to make the call option a better alternative than the forward contract? (10 points)

Explanation / Answer

Firm will buy Euro forward.

The six month forward rate = $1.1425 per euro

Amount Payable = 250,000,000 euros

Cash outflow today (250,000,000 * $1.1425) = $285,625,000

Amount payable in future = 250,000,000 euros

Interest rate to deposit in Euro = 1.5% per 6 months

Amount in Euro to be deposited = 250,000,000 euro / (1 + 0.015

Amount in euro to be deposited = 246,305,418.72 euros

Convert present value of payment using spot exchange rate of $1.150/ euro

                = $1.150 * 246,305,418.72

                = $283,251,231.53

U.S borrowing rate = 2% per 6 months

$ accumulated after 6 months = $283,251,231.53 * (1.02) = $288,916,256.16

Cash outflow today = $288,916,256.16

Exercise price = $1.1500

Future spot price = $1.25 per euro

Premium per unit = $0.023

Exercise call option = Yes

Amount payable = 250,000,000 euros

Payment per unit = $1.227 ($1.25 - $0.023)

Cash outflow today = $306,750,000 (250,000,000 * $1.227)

Exercise price = $1.1500

Future spot price = $1.05 per euro

Premium per unit = $0.023

Exercise call option = No

Amount payable = 250,000,000 euros

Payment per unit = $1.127 ($1.15 - $0.023)

Cash outflow today = $281,750,000 (250,000,000 * $1.127)

Better option is Call strike price < Future spot price

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