-0.0417 ( 12.0.) 18. (10pts) Today US based MNC is selling its product to one co
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-0.0417 ( 12.0.) 18. (10pts) Today US based MNC is selling its product to one company in Germany with the payment of euro 2 million in 90 days. Today's spot rate is $1.30/euro. (3pts) What is the risk factor of US based MNC? (4pts) If 90 days forward rate in euro is $1.34/euro, how the US company avoids the FX risk? (3pts) Does the US company have the forward profit or loss? 19. (10pts) A company decides to set up a call option contract to cover its BP 2,000,000 exposure (British Pound Payables) in 90 days. A call option contract available in the oTC market for BP 2,000,000: strike rate $1.7500/BP; premium is $0.02 per British Pound (5pts) Three month later, if the spot rate is $1.7900/BP, what is the company's decision about this call option? How much is the amount of USS cost for the company? 4Explanation / Answer
The US based MNC is exposed to transaction risk. A risk that the currency exchange between USD and Euro may go to either side, it may go up or it may go down as well. On either side one party is at risk of currency fluctuation. Now being very specific to the risk US Based MNC is involved in,
Current Exchange rate = $1.3/Euro
If the Euro goes stronger against USD in next 90 days, the USD/Eur exchange rate will come down, and the US based MNC will receive less USD against EUR. Since he is to receive full payment in Euro, that is 2 million Euro in 90 days, he is exposed to the currency fluctuation risk of 2 million Euros. If the currency Euro goes stronger against USD, the exchange between USD and Euro which is currently at $1.3 /Eur will decline to below the current exchange, and the US MNC will receive lesser USD against Euro. Thus he is exposed to the risk of loss in currency value due to currency rate fluctuation.
If 90 days forward is available for $1.34/Euro. The US MNC should immediately hedge its currency risk (transaction exposure) by selling the equivalent value forward for $1.34/Euro. By selling the currency forward for $1.34/Euro, The US MNC is limiting its currency risk. The currency may move in any direction, but the position is now hedged or say locked at $1.34/Euro. In 90 days time, when he receives payment of 2 million euros, he can sell it at $1.34/Euro to the seller of the forward contract, and thus realising a rate close to the current exchange of $1.3/Euro.
If transaction cost, brokerage cost and other costs are ignored, there is a profit of $4 basis/Euro point in this entire transaction. After three months there can be three scenarios:
Scenario 1: The exchange rate remained constant at $1.3/Euro
Here the buy rate is $1.3/Euro, and the selling rate(forward) is $1.34/Euro. There is a profit margin of $0.04/Euro.
Total profit would be 0.04* 2 million = 80,000 USD
Scenario 2: The exchange rate goes up, and above $1.34/Euro.
If the Euro goes stronger against dollar, the company would suffer a loss in forward contract, but it will be compensated with equivalent profit in cash market. So the risk is hedged. No profit no loss.
Scenario 3: The exchange rate comes down.
If the USD goes stronger against euro, and the exchange rate drops below $1.3/Euro. The MNC would suffer a loss in cash market, but equivalent profit in Forward market would neutralise the loss, hence it would be no profit no loss situation.
Answer 19: Strike rate is $1.75/BP
Premium is 0.02 per BP
Cost of trade is $1.75/BP + 0.02 = 1.77/BP
It means the spot must go above 1.77 to make a profit of the transaction
Spot price is $1.79/BP
Three months later the profitability from the transaction is 1.79 - 1.77 = $0.02/BP.
Three months later the company can exercise the call option and earn 0.02/BP from the call option, which can offset half of its total loss of $0.04/BP from the cash transaction.
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