DKNY owes 10 million Mexican pesos in 30 days for a recent shipment from Mexico. It faces the following interest and exchange rates:
Spot rate: 18.0 pesos/$
Forward rate (30 days): 18.5 pesos/$
30-day call option on pesos: strike price E=1/18.4=0.05435 $/peso
Premium (3%): 3%(1/18.4)= 0.00163 $/peso
U.S. dollar 30-day interest rate (annualized): 4%
Peso 30-day interest rate (annualized): 12%
A. What dollar cost of the payable can DKNY lock in using the forward contract? Explain whether long or short forward contract on pesos is used for hedging.
B. What is the hedged dollar cost of DKNY’s payable using a money market hedge? Find the future value for the money market hedge and explain which currency DKNY would borrow and in which invest.
C. What is the hedged dollar cost of DKNY’s payable using a call option?Notes: Find the maximum amount that DKNY would be paying if it exercises the option (use strike price E). If the expectation is that the price of Mexican peso is smaller (based on Forward rate) DKNY may expect to have a lower payable in the future. The outcome with the exercise price E will give the cap on payment that is known to DKNY in advance.
D. Suppose that DKNY expects the 30-day spot rate to be 18.6 pesos/$. Should it hedge this payable? Why or why not?