# ABC corporation has just sold

ABC corporation has just sold equipment to a French companyexports worth FF 80 million with payment due in three months. Thespot rate is FF 7.4/\$ and the 3 month forward rate is FF 7.5/\$.Also assume: 3 month French interest rate 9.00% p.a. 3 month U.S.interest rate 4.00% p.a. 3 month call option on Francs at FF 7.5/\$(strike price) 3.0% premium 3 month put option on Francs at FF7.5/\$ (strike price) 2.4% premium a) How can ABC hedge this risk?b) Which alternative would you choose and why?

ABC Corporation is assumed to be a US-based company. and willhave foreign currency (FF) receivables worth 80 million in 3 monthstime. The company has three options of hedging the exchange raterisk associated with the foreign currency receivables, namelyhedging using a forward contract, hedging using options andimplementing a money market hedge. The preferred option would bethe one which provides the cheapest rate of exchange for the 80millio FF receivables.

Option1: Forward Contract

Forward Rate = 7.5 FF/ \$

Receivables Value in \$ = R1 = 80 / 7.5 = \$ 10.67 million

Option 2: Put Option

The option of choice is the put option and not the call optionas the underlying asset, in this case, is the FF which isreceivable and hence needs to be sold at a particular rate.

Put Premium = 2.4 % of the strike price = 0.024 x 7.5 = 0.18FF

Strike Price = 7.5 FF / \$

Effective Strike Rate = 7.5 + 0.18 = 7.68 FF/ \$

Receivable Value in \$ = 80 / 7.68 = R2 = \$ 10.4167 million

Option 3: Money Market Hedge

– Borrow FF equal to the PV of the FF receivables which is (80 /1.0075) = FF 79.4045 million

– Convert this borrowing into \$ at the current exchange rate of7.4 FF/\$ to obtain (79.4045/7.4) = \$ 10.73034 million

– Deposit this borrowing into an account earning the US interestrate of 4 % per annum for three months to yield (10.73034 x 1.0033)= \$ 10.7657 million

– Payoff FF loan liability of 80 million with thereceivables.

– Effective Exchange Rate = (Receivables / \$ Deposit Value) = 80/ 10.7657 = 7.43 FF / \$

Receivables Value in \$ = 80 / 7.43 = R3 = \$ 10.767 million

As among R1, R2 and R3, R3 is possesses the greatest value byproviding the cheaperst effective exchange rate the same should bechosen.

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