The foreign exchange exposure of the dollar payment due in four months can be hedged using the following derivative products:
Forward rate offered by Pecunia Bank;
Exchange-traded futures contracts; and
Exchange-traded options contracts
Using the forward rate
Payment in Swiss Francs = US$5,060,000/1·0677 = CHF4,739,159
Using futures contract
Since a dollar payment needs to be made in four months' time, CMC Co needs to hedge against Swiss Francs weakening.
Hence, the company should go short and the six-month futures contract is undertaken. It is assumed that the basis differential
will narrow in proportion to time.
Predicted futures rate = 1·0647 + [(1·0659 – 1·0647) x 1/3] = 1·0651
[Alternatively, can predict futures rate based on spot rate: 1·0635 + [(1·0659 – 1·0635) x 4/6] = 1·0651]
Expected payment = US$5,060,000/1·0651 = CHF4,750,728
No. of contracts sold = CHF4,750,728/CHF125,000 = approx. 38 contracts
Using options contracts
Since a dollar payment needs to be made in four months' time, CMC Co needs to hedge against Swiss Francs weakening. Hence, the company should purchase six-month put options.
Exercise price US$1·06/CHF1
Payment = US$5,060,000/1·06 = CHF4,773,585
Buy 4,773,585/125,000 = 38·19 put contracts, say 38 contracts
CHF payment = CHF4,750,000
Premium payable = 38 x 125,000 x 0·0216 = US$102,600
In CHF = 102,600/1·0635 = CHF96,474
Amount not hedged = US$5,060,000 – (38 x 125,000 x 1·06) = US$25,000
Use forward contracts to hedge this = US$25,000/1·0677 = CHF23,415
Total payment = CHF4,750,000 + CHF96,474 + CHF23,415 = CHF4,869,889
Exercise price US$1·07/CHF1
Payment = US$5,060,000/1·07 = CHF4,728,972
Buy 4,728,972/125,000 = 37·83 put contracts, say 38 contracts (but this is an over-hedge)
CHF payment = CHF4,750,000
Premium payable = 38 x 125,000 x 0·0263 = US$124,925
In CHF = 124,925/1·0635 = CHF117,466
Amount over-hedged = US$5,060,000 – (38 x 125,000 x 1·07) = US$22,500
Using forward contracts to show benefit of this = US$22,500/1·0677 = CHF21,073
Total payment = CHF4,750,000 + CHF117,466 – CHF21,073 = CHF4,846,393
Advice
Forward contracts minimise the payment and option contracts would maximise the payment, with the payment arising from the futures contracts in between these two. With the option contracts, the exercise price of US$1·07/CHF1 gives the lower cost. Although transaction costs are ignored, it should be noted that with exchange-traded futures contracts, margins are required and the contracts are marked-to-market daily.
It would therefore seem that the futures contracts and the option contract with an exercise price of US$1·06/CHF1 should be rejected. The choice between forward contracts and the 1·07 options depends on CMC Co's attitude to risk. The forward rate is binding, whereas option contracts give the company the choice to let the option contract lapse if the CHF strengthens against the US$. Observing the rates of inflation between the two countries and the exchange-traded derivatives this is likely to be the case, but it is not definite. Moreover, the option rates need to move in favour considerably before the option is beneficial to CMC Co, due to the high premium payable.
It would therefore seem that forward markets should be selected to minimise the amount of payment, but CMC Co should also bear in mind that the risk of default is higher with forward contracts compared with exchange-traded contracts.
