Question: You are the financial manager of a U.S. Company which sold watches to a Belgian company for $5,400,000 when the spot rate of $/€ was 1.0800. The Belgian Company would pay in euros and it would have paid €5,000,000 in two equal payments on February and May 1st. By the time the order was received and booked, the euro strengthened to $1.1020/€. You now wonder if your company should hedge against a reversal of the recent trend of the euro. Evaluate the following four approaches:
1. Hedge in the forward market. The 3-month forward exchange quote is $1.1080/€ and the 6-month forward quote is $1.1125/€.
2. Hedge in the money market. You could borrow euros from the Frankfurt branch of its U.S. bank at 7.00% per annum.
3. Hedge with foreign currency options. February put options are available at strike price of $1.1100/€ for a premium of 2.2% per contract, and May put options are available at $1.1100/€ for a premium of 1.5%. February call options at $1.1000/€ could be purchased for a premium of 3.2%, and May call options at $1.1100/€ are available at a 2.5% premium.
4. Do nothing. You could wait until the sales proceeds were received in February and May hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market. You estimate the cost of equity capital to be 14% per annum. As a small firm, you are unable to raise funds with long-term debt. U.S. T-bills yield 3.5% per annum. What should you do?