- United Airlines has just signed a contract to purchase some A320 planes from Airbus for 200,000,000 euros. The payment is due six months or 180 days later. You are in the Treasury department of United Airlines and need to make a recommendation to the Treasurer regarding how best to hedge the exchange rate risk of this transaction. You have gathered the following information:
• The spot exchange rate is $1.2000/€. That is to say, 1 euro = 1.2000 US dollars
• The six-month forward rate is $1.2100/€
• The company’s cost of capital is 10% per annum.
• The euro 6-month borrowing rate is 4% per annum (or 2% for 6 months)
• The euro 6-month lending rate is 2% per annum (or 1% for 6 months)
• The US dollar 6-month borrowing rate is 5% per annum (or 2.5% for 6 months)
• The US dollar 6-month lending rate is 3% per annum (or 1.5% for 6 months)
• The premium on six-month call options on the euro with strike price $1.2100 is 2%.
You need to compute the total cost in dollars of each hedging alternative. Note that the phrase “total cost in dollars” refers to the total cash outflow in dollars when the payment is made in six months. Also, keep in mind that cash flows that occur at different points in time are not directly comparable. You need to put them on a common footing by computing their present value or future value.
a) Suppose that United Airlines were to hedge its transaction exposure using a forward contract. Should the firm sell or buy euros forward? What is the total cost in dollars (i.e., what will be the total cash outflow in dollars in six months)? (3 points)
b) Suppose United Airlines chooses a money market hedge. Spell out the transactions that the firm will need to undertake to implement this hedge. What is the total cost in dollars using this hedge? (3 points)
c) Suppose United Airlines decides to hedge using a call option on the euro.
(i) Suppose that the spot rate in 6 months is $1.15 per euro. What will be the total cost in dollars after taking into account (the future value of) the cost of the option? (2 points)
(ii) Suppose that the spot rate in 6 months is $1.25 per euro. What will be the total cost in dollars after taking into account (the future value of) the cost of the option? (2 points)
d) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation (2 points)
e) Suppose that you expect the euro to depreciate. How much does the euro need to depreciate in order to make the call option a better alternative than the forward contract? In other words, how low does the euro have to go in value to make the call option a better alternative than the forward contract? Explain your calculations. (3 points)
b) This question is based on Exhibit 13.3 on page 388 in chapter 13 of the textbook. In this example, Nestle’s cost of equity is calculated using two different market portfolios, a domestic market portfolio and a global market portfolio. Which of these is more appropriate? Support your answer with appropriate arguments. (8 points)
- Berkeley Quantum Fund, a U.S.-based investment partnership, borrows 200 million yen for 3 years from Matsushita bank. Interest on this loan is payable annually at a rate of 3%. The current exchange rate is ¥108.00/$, and the yen is expected to strengthen against the dollar by 2% per annum. Compute the cash flows of the loan both in yen and in dollars, and calculate the effective cost (i.e., the effective interest rate) of this yen-denominated loan in dollars (based on the expected change in the exchange rate). (10 points)
- Santa Isabel, a food company located in Chile in South America, is planning to expand its operations internationally, and is considering buying a relatively small California-based grocery chain store that specializes in South American food.
Annual revenues are expected to be a constant amount of $5,000,000 and the cost of goods, $3,000,000. General and Administrative expenses are estimated at $500,000 per year and annual depreciation expense at $500,000.
The California subsidiary will pay 80% of its accounting net profit to the parent firm, Santa Isabel, as an annual cash dividend. Chilean taxes are calculated on grossed up dividends from foreign countries, with a credit for host-country taxes already paid. The corporate income tax rate in U.S. is 30% and the tax rate in Chile is lower at 25%. Therefore, no additional income taxes will be payable in Chile.
Santa Isabel will base its valuation of the investment on after-tax dividends received at the end of each of the first three years plus a terminal value as at the end of year 3. The Chilean currency is the Chilean peso and is denoted CLP$. The exchange rate against the US dollar is as follows. The current exchange rate is CLP$ 700.00/$, and the Chilean peso is expected to depreciate by 5% each year.
Compute the expected cash flow, both in dollars and in pesos, Santa Isabel will receive at the end of the first year. (10 points)
Sample Solution