The U.S.-based Minnesota Mining Company (MMC) has a one-year account receivable
ID: 2791911 • Letter: T
Question
The U.S.-based Minnesota Mining Company (MMC) has a one-year account receivable due from a German manufacturing company worth Euro 1,000,000 The current spot rate is $0.8800 /Euro, and the 1-year forward Euro is selling at $0.8950/Euro. MMC can borrow and lend Euro in Frankfurt at 4% per annum. MMC has a weighted average cost ofcapital of 12% per annum. a. Explain MMC's forward market hedge. What will be its dollar proceeds from the receivable under this hedge? b. What is the breakeven rate of interest at which MMC will be indifferent between executing a forward market hedge and a money market hedge? If MMC's investments yield, on average, 10% pa, which hedge is superior? c. Suppose twelve month call and put options on Euros are available. Each has an exercise price of $0.8850 and a premium of 1%. d. G) Would they BUY OR SELL a 12-month CALL OR PUT on USS OR EURQ? (Circle the options) (i) What will be MMC's total cost of buying the option contract today? (iii) What is MMC's net US dollar proceeds from the Euro 1,000,000 reccivable if in 12- months the spot rate is $0.8600/Euro? (iv) What is MMC's net US dollar procceds from the Euro 1,000,000 receivable if in 12- months the spot rate is $1.0500/Euro?Explanation / Answer
a) Since MMC has FC(Euro) receivables, it may enter into a Forward Contract to sell Euro after 1 year.
$ proceeds from the receivables under this hedge = $ 0.895 * 1,000,000 = $ 895,000
b) At break-even rate of interest, the interest rate parity holds good i.e.,
Euro 1 * (1+0.04) = $ 0.8800 * (1+r)
Euro 1.04 = $ 0.88 * (1+r)
1+r = 1.04/0.88
1+r = 1.1818
r = 0.1818 = 18.18%
Hence, the break-even rate of interest = 18.18%
c) Return on investment = 10% ; Break-even rate of interest = 18.18%
Since Return on investment < Break-even rate of interest, the $ proceeds under the money market hedge would be less than the $ proceeds under the forward market hedge. Hence forward market hedge is superior in such case.
d)
(i) MMC has receivables in Euro (after 1 year). Hence, it shall sell Euro i.e,. it shall Buy(Hold) a Put Option on Euro
(ii) Cost of buying the Option Contract today
= Euro 1,000,000 * $0.885 * 1% = $ 8,850
(iii) Since the Strike Price (Exercise Price) of Put Option > Spot Rate of Euro, the Option is exercised and
$ proceeds in 12 months = $0.885 * 1,000,000 = $ 885,000
less: Interest on amount borrowed to pay the premium [ $ 8850* 12%] = ($ 1,062)
Net $ proceeds in 12 months = $ 883,938
(iv) Since the Strike Price (Exercise Price) of Put Option < Spot Rate of Euro, the Option is not exercised
$ proceeds from sale of Euro at Spot = $ 1.05 * 1,000,000 = $ 1,050,000
less: Interest on amount borrowed to pay the premium [ $ 8850* 12%] = ($ 1,062)
Net $ proceeds in 12 months = $ 1,048,938
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