Techniques for Hedging Receivables. SMU Corp. has future receivables of 4,000,00

Question

Techniques for Hedging Receivables. SMU Corp. has future receivables of 4,000,000 New Zealand dollars (NZS) in one year. It must decide whether to use options or a money market hedge to hedge this position. Use any of the following information to make the decision. Verify your answer by determining the estimate (or pr 2. distribution) of dollar revenue to be received in one year for each type of hedge. Spot rate of NZS S54. One-year call option: Exercise price One-year put option: Exercise price $50, premium-$07 $.52, premium $.03 U.S. New Zealand One-year deposit rate 996 6% TOne year borrowing rate Rate Probability $50 20% 51 50 .53 Forecasted spot rate of NZS 30

Explanation / Answer

New zeland dollrs to be received afer the one year = 4000000
current sopt rate per USD =0.54
Forecasted NZ$ rate afer one year = 0.514 (from below working note )

Probability   Rate   Rate*Probability  
20%           0.5           0.1  
50%           0.51       0.255  
30%           0.53       0.159  
                                  0.514  
When we compare current spot rate with the probalable rate after 1 year
The Future spot rate was lower than the current spot rate
So this neccissiates us to take any of the provided option of either to opt for
Option hedging or to go for Money market hedging


Now we have two options to create a hedge
A)options-Put option
B)Money Market hedge


A)Foreign Currency Option:
Foreign currency option is the right (not an obligation) to buy or sell a currency at an agreed exchange rate (exercise price) on or before an agreed maturity period. The right to buy is called a call option and right to sell is put option.

Put Option
Since future forecasted rate is lower than the current spot rate ..
THe given call option is not suitable for hedging
With this we are taking the put option as our hedging because the rate quotaed was higher than the Forecasted rate.

Since possible spot rate of $0.53 is there then choosing of put option not required,but incase of option purchase we have to forgo our premium paid i.e.$0.03

B)Money Market Hedge:
A money market hedge involves simultaneous borrowing
and lending activities in two different currencies to lock in the home currency
value of a future foreign currency cash flow. The simultaneous borrowing and
lending activities enable a company to create a homemade forward contract

Money market hedge choosen
1.    Borrow NZ$3,703,704 (NZ$4,000,000/1.08 = NZ$3,703,704)
2.    Convert NZ$3,703,704 to $2,000,000 (at $.54 per New Zealand dollar)
3.    Invest $2,000,000 to accumulate $2,180,000 at the end of one year ($2,000,000 × 1.09 =
$2,180,000)
Since the $ to be received under the money market hedge is morethan the $ recivebale in Currency option it is advisable to choose Money market hedge.
==>(1960000*20%)+(1960000*50%)+(2000000*30%) = $1972000 is less than the $2180000 to be recivebale under moneymarket hedge

Possible SpotRate Premium Excercise price $ TO BE RECEIVED(less of Premium) Excercise Total proceeds $USD for NZ$ Probability $.50 $0.03 $.52 $0.49    yes 1,960,000 20% $.51 $0.03 $.52 $0.49    yes 1,960,000 50% $.53 $0.03 $.52 $0.50    No 2,000,000 30%

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