Your firm is a U.S.-based exporter of toys. You have sold an order to an Italian firm for €1,000,000 worth of toys. Payment from the Italian firm (in €) is due in 1 year.
Your firm wants to hedge the receivable. The one-year interest is 2% in the U.S. and 4% in the euro zone. The spot exchange rate is $1.30/ €.
a.Using the money market hedge, how much does your firm need to borrow and from whom now? The U.S. bank or the euro bank? And what is your today’s revenue in terms of dollar?
b. Using the forward market hedge, what is an appropriate forward exchange rate for the euro?
c. Using the option market hedge, which option is appropriate, a call option or put option? Suppose that the exercise price is $1.25/€ and the option premium is $0.04. If the exchange rate is $1.20/€ in 1 year, would you exercise the option or not? If you exercise the option, figure out the payoff.