Question: Aquatech. Aquatech is a U.S.-based company that manufactures, sells, and installs water purification equipment. On April 11, the company sold a system to the City of Nagasaki, Japan, for installation in Nagasaki's famous Glover Gardens (where Puccini's Madame Butterfly waited for the return of Lt. Pinkerton). The sale was priced in yen at ¥20,000,000, with payment due in three months.
Note that the interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot ¥118.255/$, for example, is a mid-point range. On April 11, the spot yen traded in London from ¥118.30/$ to ¥117.550/$. Aquatech's Japanese competitors are currently borrowing yen from Japanese banks at a spread of two percentage points above the Japanese money rate. Aquatech's weighted average cost of capital is 16%, and the company wishes to protect the dollar value of this receivable.
3-month options from Kyushu Bank:
- Call option on ¥20,000,000 at exercise price of ¥118.00/$: a 1% premium.
- Put option on ¥20,000,000, at exercise price of ¥118.00/$: a 3% premium.
a. What are the costs and benefits of alternative hedges? Which would you recommend, and why?
b. What is the break-even reinvestment rate when comparing forward and money market alternatives?