Question: Assume that Pomo Limited, a US based firm, expects to receive S$800,00
ID: 2796069 • Letter: Q
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Question: Assume that Pomo Limited, a US based firm, expects to receive S$800,000 in one year. The existing...
Assume that Pomo Limited, a US based firm, expects to receive S$800,000 in one year. The existing spot rate of the Singapore dollar is US$0.74. The one-year forward rate of the Singapore dollar is US$0.76. Pomo created a probability distribution for the future spot rate in one year as follows:
Future Spot | Rate Probability
US$0.75 | 20%
US$0.77 | 50%
US$0.81 | 30%
Assume that one-year put options on Singapore dollars are available, with an exercise price of US$0.77 and a premium of US$0.04 per unit. One-year call options on Singapore dollars are available with an exercise price of US$0.74 and a premium of U$0.03 per unit. Assume the following money market rates:
U.S. | Singapore
Deposit rate: 9% | 6%
Borrowing rate: 10% | 7%
Briefly discuss the optimal hedge against the no hedge position of the company.
Explanation / Answer
Their are three hedging options available to the firm -
1) Forward market hedge
2) Options Hedge
3) Money market hedge
The option that provides the maximum receivable to the company will be the most optimal one.
1) Forward market hedge
The company will enter into a forward contract to sell S$800,000 after one year @ forward rate.
Forward rate - S$ 1 = US$ 0.76
Amount received after one year = S$ 800,000 x US$ 0.76 / S$1 = US$ 608,000
2) Options Hedge
The company will buy the put options worth S$ 800,000 after paying the premium on put options, so that it can have sell the S$ 800,000 after one year @strike price.
Strike Price - S$ 1 = US$ 0.77
Premium paid - S$ 1 = US$ 0.04
Amount received = (S$ 800,000 x US$ 0.77 / S$ 1) - (S$ 800,000 x US$ 0.04 / S$1) = US$ 584,000
3) Money Market Hedge
Since we have a receivable, we will follow the following steps -
i) Borrow such amount of foreign currency (S$) that principal along with interest will be completely paid off after one year.
Amount to be borrowed = S$ 800,000 / (1.07) = S$ 747,663.55
ii) Convert this amount to US$ @current spot rate and deposit the same in the US market -
US$ equivalent of amount borrowed = S$ 747,663.55 x US$ 0.76 / S$ 1 = US$ 568,224.30
iii) Amount received after one year would be the amount deposited along with interest -
Amount received = US$ 568,224.30 + 9% x US$ 568,224.30 = US$ 619,364.49
4) No hedge
Expected Future Spot rate = US$ 0.75 x 0.20 + US$ 0.77 x 0.50 + US$ 0.81 x 0.30 = US$ 0.778 or US$ 0.78
Amount received after one year = S$ 800,000 x US$ 0.78 / S$ 1 = US$ 624,000
Well, no hedging would be the best option as it would net the highest amount to the company. However, in case the company does wants to hedge, the optimal hedge would be a Money Market Hedge.
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