6. At this point, the demand in Mexico is pick up nicely. Your company is curren

Question

6. At this point, the demand in Mexico is pick up nicely. Your company is currently repatriate 47 million pesos per year from Mexico through ESL class offering and English learning material sales. In addition your company is also import Spanish learning material package produced in Mexico and the company needs to pay about 7 million peso a year from an independent subcontractor located in Mexico. Given recent exchange rate volatility increase, you are asked to identify a good alternative to hedge your company’s transaction exposure.

a. Should you hedge peso denominate cash inflow (receivable from export English learning materials and earnings from operation) and cash outflow (payable for import) separately or total cashflows (cash inflow plus cash outflow) or net cashflows (the difference between cash inflow and case outflow)? Why?

b. Based on the following information, please calculate the amounts you would have received based on the following information. You have alternatives of using forward hedge, money market hedge, futures and options. Based on your analysis and calculation, which hedging alternative will you recommend?

Summarv of market information Spot rate Bid Ask $.051 Bid $0.047 USA 2.5% Call option $.0515 2% 0.00103 $515 Bid $0.048 $0.06 Ask $0.057 Mexico 7% Put option $.0515 2.5% 0.0012875 $643.75 Ask $ 0.058 orward contract information USD per peso Monev market rate information Annual Interest rate Option Information American Option 500,000 pesos per contract Exercise price ($ Option premium (% of exercise brice Option premium (S) er pesd Total premium (S) per contract Futures Contract Information USD per peso 500,000 pesos per contract

Explanation / Answer

1. If the cash inflow and outflow timing is same then there is no point hedging separately at the moment as hedging involves cost and hedging requirements are not there if export = import.

Total amount that needs to be hedged 40 million pesos per year which needs to be converted back into dollars.

2. Assuming you will get net 40 Million Pesos at the end of one year:

a. Forward contract hedge, in this case you simply buy a forward contract 0.047$ per peso.

This way you have fixed your conversion rate, now whether you the spot rate will be 0.05 or 0.045 you will get 0.047$ per peso.

b. Money market hedge:

In this case, you borrow pesos equivalent to what you will receive at the end of the year:

40 Million Pesos you will receive

1. Borrow PV of 40 Million Pesos: i.e. 40/1.07 = 37.38 Million Pesos

2. Convert them to dollars at spot rate: 37.38*0.051 = 1.91 Million dollars

3. Earn 2.5% in money market in USA on 1.91 Million dollars to get 1.95775 Million dollars at the end of the year.

4. In the forward contract you would have received 0.047*40 = 1.88 Million dollars and thus, money market hedge is better in this case.

c. Hedging by option: You need to have a right to sell pesos at a later date: Put option will give 0.0515$ per peso.

Premium cost for 40 million : 643.75*40/0.5 = 51500 $

Suppose at the end of the year peso is selling for less than 0.0515 $, you exercise the put option to get 0.0515*40 = 2.06 Million dollars

Net receipt in this case is 2.06 - 51500*(1.025)/10^6 = 2.01 Mn $

Here the payout is even better as the relative hedging cost is lower wherein you are getting right to sell the pesos at a rate of 0.0515 for a premium which is lesser than the interest rate differential you earn in money market.

d. In case of futures, you pre-fix selling price of pesos at 0.048$ which again is lesser than the above option which is pre-fix your dollar input at 0.048*40 = 1.92$

Hence, you should choose options for hedging as the hedging cost is relatively lower resulting in higher dollar payout.

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