Though the real estate market has been depressed in some countries due to the aftermath of the global financial crisis, the markets in a few countries or cities have kept their robust growth in prices and expansions. A noteworthy case is the commercial and residential properties in Copenhagen, Denmark.
To tap into the above market, you have already entered into a sizeable investment in a commercial property. The currency of Denmark is Danish Kroner, or Krone, and we use DKK for it hereon.
In brief, you have made arrangements for the purchase of a commercial property in Copenhagen for DKK 210.00 million. The functional currency of your company is the US dollar. Through the help and guidance of your real estate agent, lots of detailed arrangements, including signing of the contract, computing the closing costs, funding the purchase, etc., have already been taken care of. The only remaining item that is the subject of this inquiry is a lump sum payment of DKK 11,800,000.00 upon the occupancy (delivery) of the property, which is scheduled for nine months from today.
Considering the variations in the currency market these days, you are very concerned that your expected payment of DKK 11,800,000.00 may impose unnecessary foreign exchange risk for your company. You are considering several hedging alternatives to reduce the exchange rate risk arising from this purchase. You evaluate your position in USD at all times. The following information is made available to you today:
The spot exchange rate is DKK 6.8911/$
The nine month forward rate is DKK 6.9866/$
Forecast of the management for the end of the ninth month is DKK 7.10/$
The company’s cost of capital is 10 percent per year.
The Danish 9-month borrowing or lending rate is 5.5 % per annum
The U.S. 9-month borrowing or lending rate is 3.2 % per annum
A call or put option for the strike price of DKK 6.90/$ carries a premium of 1.14 percent for this period.
Based on the above information, first please read again the entire instructions above, then answer the following FIFTEEN questions (why so many? See above!).
1. If your company chooses to hedge this exposure in the forward market, calculate the outcome of this hedge in the US dollar.
2. If your company chooses to hedge this exposure in the forward market, the outcome of this hedge in the US dollar is certain (=1, enter 1 in the template), risky (=2, enter 2 in the template), certain and risky (=3, enter 3 in the template).
3. If your company hedges this exposure in the money market, calculate the outcome of this hedge today assuming the company borrows and invests at the prevailing market rates that are cited above.
4. If your company hedges this exposure in the money market, calculate the outcome of this hedge in nine months assuming the company borrows and invests at its WACC rate.
5. If your company hedges this exposure in the money market, the outcome is (chose the best answer) Known (=1), unknown (=2), risky (=3), known and certain (=4).
6. If the options market is employed as a hedge, and if the company eventually exercises the option at the very end of the period, calculate the amount from only exercising the option.
7. If the options market is employed as a hedge, and if the company eventually exercises the option at the very end of the period, calculate the total outcome of this hedge. The company uses its WACC when it enters the options market.
8. If the options market is employed as a hedge, and if the company does not exercise the option, calculate the cost of the option at the beginning of the period. The company uses its WACC when it enters the options market.
9. If the options market is employed as a hedge, and if the company does not exercise the option, calculate the cost of the option at the very end of the period. The company uses its WACC when it enters the options market.
10. If the options market is employed as a hedge, and if on the very last day of the option maturity, the spot rate would be DKK 7.19, calculate the total outcome of the option hedge.
The company uses its WACC when it enters the options market.
11. If the options market is employed as a hedge, and if on the very last day of the option maturity, the spot rate would be DKK 6.91, calculate the total outcome of the option hedge.
The company uses its WACC when it enters the options market.
12. If the company chooses not to hedge at all, the outcome is known (=1), unknown (=2).
13. If the company chooses not to hedge at all, the outcome is certain (=1), risky (= 2).
14. If the company chooses not to hedge at all and its forecasts turn out to be correct, calculate the outcome of this scenario.
15. Some of the hedging strategies that are covered in Chapter 10, e.g., options, futures, etc., are simple examples of derivatives. I agree (=1). I disagree (=2).