A cFO of French exporter is asked to evaluate exposure against USD over the next 12 months and to propose a hedging strategy. The current direct spot rate is 0.75. In 6 months (time 1) the exchange rate will be either 0.80 or 0.70. In 12 months (time 2) the direct spot rate can be either .95 or .75, if the sport rate in six months is .80, and .75 or .55, if the sport rate in six months is .70. If Euro appreciates in six months, and again in twelve months, the exporter will face very fierce competition from its only Us competitor.
Therefore, we can expect the following cash flows in twelve months: at S=0.95 (11 million, at S=.75 €13 million, and at 5=55 €6 million. Six month nominal us interest rate is 4% percent per year (APR), while three months nominal Euro interest rate is 2% per year (APR). European rate is expected to increase to 3% in six months, while the US rate is expected to stay unchanged.
a. Plot the spot rate and cash flows one year from now.
b. Propose and defend (without giving numbers) two hedging strategies by stating pros and cons, which would eliminate as much foreign exchange exposure as possible.