Assignment: Oregon Transportation Inc. (OTI) has just signed a contract to purchase light rail cars from a manufacturer in Germany for Euro 2,500,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, OTI is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
The spot exchange rate is $1.1740/?
The six month forward rate is $1.1480/?
OTI's cost of capital is 12% per annum
The Euro zone 6-month borrowing rate is 7% per annum (or 3.5% for 6 months)
The Euro zone 6-month lending rate is 5% per annum (or 2.5% for 6 months)
The U.S. 6-month borrowing rate is 6% per annum (or 3% for 6 months)
The U.S. 6-month lending rate is 4.5% per annum (or 2.25% for 6 months)
December put options for ?625,000; strike price $1.18, premium price is 1.5%
OTI's forecast for 6-month spot rates is $1.19/?
The budget rate, or the highest acceptable purchase price for this project, is $2,975,000 or $1.19/? ($2,975,000/?2,500,000)
Question 1: OTI chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be __________.
(a) $2,500,000
(b) $2,870,000
(c) $2,935,000
(d) $2,975,000
Question 2: OTI would be ____________ by an amount equal to ____________ with a forward hedge than if they had not hedged and their predicted exchange rate for 6 months had been correct.
(a) better off, $105,000
(b) better off, Euro 105,000
(c) worse off, $105,000
(d) worse off, Euro 105,000