American Airlines has just signed a contract to purchase an A340-600 aircraft fr

Question

American Airlines has just signed a contract to purchase an A340-600 aircraft from Airbus for 250,000,000 euros. The payment is due six months later. As the Lead Risk Analyst of American Airlines, you are considering how best to hedge the exchange rate risk arising from the purchase, and need to make a recommendation to the Treasurer based on your analysis. You have gathered the following information: • The spot exchange rate is $1.2000/€ • The six month forward rate is $1.1950/€ • The cost of capital of American Airlines is 12% per annum. • The premium on a six-month call option on the euro with strike price $1.2000 is 2%. You are trying to help decide between the following two alternatives: • Hedging with a forward contract • Hedging using a call option on the euro a) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Justify your recommendation. (No calculations are necessary.) (5 points) b) Suppose that you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Justify your recommendation (No calculations are necessary.) (5 points) c) 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 total cash outflow under the call option be less than that under the forward contract? Support your answer with calculations. (5 points)

Explanation / Answer

a) If the Euro strongly appreciates, American Airlines will be paying more Dollars for the Aircraft. Hence it would want the right to buy dollars at a lower price. Thus in this case, forward contract would allow it to buy dollars at 1.195 USD to the Euro. It would thus end up paying 1.195*250 = 298.75 Million USD for the aircraft.

b) If the Euro depreciates, American airlines would be paying less dollars for the aircraft. Thus, it would be advisable to go with a 6 month forward contract that enables american airlines to buy Euro's at a lower exchange rate of 1.195 USD to the Euro. If the Euro depreciates to much less than 1.195 USD to Euro then it may be worth looking at using the call option provided the value of the Euro depreciates to below the value calculated in part c)

c) Call option gives the holder the right to buy euros at 1.2 USD to the EURO.

In order for the call option to be a better option at hedging than the forward contract, then the 2% premium paid on the call option should be less than the value that the Euro depreciates to after 6 months

Thus, the Euro can depreicate upto $1.18/Euro for the call option to be better than the forward contract.

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