I need some help on the following question. Thank you.
Suppose the dollar-euro spot rate is 1.20 and the current 30-day forward
rate is 1.25.
(a) You have an obligation to pay a French supplier of wine 10 million euros in 30 days and have contracted with a U.S. distributor to sell the wine for USD 13 million. How many dollars can you make if you hedge your risk using the forward market?
(b) Is it possible that you could lose money if you do not hedge your risk?
(c) Suppose that you could get a call option that would allow you to buy
euros in 30 days at 1.27. Describe the merits of buying this option relative
to using the forward market as in (a).
(d) Now suppose you are a speculator facing the same spot and forward rates
as above and you have USD 1 million. Suppose you bought euros forward. In 30
days, the spot rate for the dollar turns out to be 1.3. How many dollars did you make or lose from this transaction?
(e) Now suppose instead that the spot rate stayed at the same over the next
30 days. If you bought euros forward, how many dollars did you make or lose
from this transaction?
Think it through. $1.25 = E1 30-day forward. So to buy 10 million E 30 days from now, to hedge it will cost $12.5 million, profit=$0.5 million
b) absolutely
c) This call option says that 30 days from now, you have the option of buying euros at $1.27. If the spot market is above $1.27 you will exercise (use) this option, if below you will not. The will certainly be some kind of up-front fee for getting this option.
d) and e) take it from here.
for d) is it 0.3 million profit because you will exercise the option
for e) is it 0.5 million profit
Sure, I can help you with that. Let's break down each question and explain how to get the answers.
(a) To calculate the amount of dollars you can make if you hedge your risk using the forward market, you need to consider the difference between the spot rate and the forward rate.
In this case, the spot rate is 1.20 and the forward rate is 1.25. This means that the forward rate is higher, indicating that the euro is expected to appreciate against the dollar.
To hedge your risk, you would sell euros forward at the rate of 1.25. Since you have an obligation to pay 10 million euros, you would receive 10 million euros when you sell them forward.
To calculate how many dollars you can make, you need to multiply the amount of euros by the forward rate. Therefore, 10 million euros * 1.25 = 12.5 million dollars.
So, if you hedge your risk using the forward market, you can make 12.5 million dollars.
(b) It is possible to lose money if you do not hedge your risk. If you decide not to hedge and the euro depreciates against the dollar, meaning the spot rate becomes lower than the forward rate, you would need to pay more dollars to fulfill your obligation of 10 million euros. This would result in a loss.
(c) The call option allows you to buy euros at a specified rate of 1.27. If you use a call option instead of forward market hedging, you have the right but not the obligation to buy euros in 30 days at the predetermined rate.
The merits of buying this option relative to using the forward market in (a) are twofold. First, with the call option, if the spot rate turns out to be better than the strike rate of 1.27, you can choose not to exercise your option and instead buy euros in the spot market at a more favorable rate. Secondly, buying a call option gives you protection against a possible appreciation of the euro, as you have the right to buy euros at a predetermined rate.
(d) If you are a speculator and bought euros forward with USD 1 million, and in 30 days the spot rate turns out to be 1.3, you can calculate your profit or loss.
Since you bought euros forward with USD, you would receive euros at the forward rate of 1.25. With USD 1 million, you would receive 1 million euros (USD 1 million / 1.25 = 1 million euros).
If the spot rate is 1.3, you can calculate the value of the euros in dollars by multiplying the amount of euros by the spot rate. Therefore, 1 million euros * 1.3 = 1.3 million dollars.
To calculate your profit or loss, subtract the initial investment (USD 1 million) from the final value (USD 1.3 million). Therefore, you made a profit of USD 0.3 million.
(e) If the spot rate stays the same over the next 30 days, when you bought euros forward, there would be no profit or loss. The spot rate remaining the same means there is no change in the value of the euros against the dollar. Therefore, you would not make or lose any money from this transaction.