Instruction 9.2:
Use the information for following problem(s).
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 $1.40/euro
∙ The six month forward rate is $1.38/euro
∙ OTI's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 625,000; strike price $1.42, premium price is 1.5%
∙ OTI's forecast for 6-month spot rates is $1.43/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is
$3,625,000 or $1.45/euro
-Refer to Instruction 9.2. 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.

Question

Quizplus · Accepted Answer

By using a forward hedge, OTI can lock in a rate of $1.38/euro, which is better than their predicted exchange rate of $1.43/euro. Therefore, they would be better off with the hedge.

The amount saved by using the hedge can be calculated as follows:

Original cost in dollars without hedge = euro 2,500,000 x $1.40/euro = $3,500,000 
Cost in dollars with predicted exchange rate = euro 2,500,000 x $1.43/euro = $3,575,000

Amount saved with hedge = $3,575,000 - ($2,500,000 x $1.38/euro) = $125,000.

Instruction 9.2: Use the Information for Following Problem(s)