FNCE3004 Lecture Notes - Lecture 7: Swedish Krona, Foreign Exchange Spot, Mexican Peso
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Coleman needs 100,000 euros in 1 year, then it could convert dollars to euros and deposit the euros in a bank today.The Coleman purchasing team received this price quote of â¬100,000 today where the current spot rate was $1.1800/â¬, which equates to the U.S. dollar price of $118,000.
Coleman's director of finance now wondered if the firm should hedge against more fluctuation in the exchange rate.
Three approaches were possible:
1) Hedge in the forward market. The 1-year forward exchange quote was $1.20/â¬.
2) Hedge in the money market. Coleman could borrow U.S. dollars from its U.S. bank at 7.00% per annum. The EU investment rate is 9.00% per annum.
3) Hedge with foreign currency options. The day the Euros are needed the call options at $1.2000/⬠could be purchased for a premium of $0.03. (Note: First you need to figure out the option premium in percentage. The spreadsheet cell D32 is not set-up for USD)
Discuss if Coleman should hedge its transaction exposure of EUR 100,000. If you recommend that the company should hedge, which of the hedging alternatives would better serve Northwind shareholders?
Assumptions | Value | |
1-year A/P in ⬠| ? | |
Spot rate, ($/â¬) | ? | |
1-year forward rate, ($/â¬) | ? | |
EU investment rate | ? | |
borrowing rate, USD, per annum | ? | |
Coleman's WACC | 10.000% | |
Time to maturity (in months) | 12.00 | |
Options on Euro: 1-year Strike price, ($/â¬) | Call Option | |
Strike price ($/£) | ? | |
Option premium ? Solve this using step by step calculations |
What is the solution to this problem?
Vino Veritas Company, a U.S.âbased importer of wines and spirits, placed an order with a French supplier for 1,500 cases of wine at a price of 250 euros per case. The total purchase price is 375,000 euros. Relevant exchange rates for the euro are as follows:
Date | Spot Rate | Forward Rate to October 31, 2015 | Call Option Premium for October 31, 2015 (strike price $1.25) | ||||||
September 15, 2015 | $ | 1.25 | $ | 1.31 | $ | 0.040 | |||
September 30, 2013 | 1.30 | 1.34 | 0.075 | ||||||
October 31, 2015 | 1.35 | 1.35 | 0.100 | ||||||
Vino Veritas Company has an incremental borrowing rate of 12 percent (1 percent per month) and closes the books and prepares financial statements at September 30. |
a. | Assume that the wine arrived on September 15, 2015, and the company made payment on October 31, 2015. There was no attempt to hedge the exposure to foreign exchange risk. Prepare journal entries to account for this import purchase. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.) |
b. | Assume that the wine arrived on September 15, 2015, and the company made payment on October 31, 2015. On September 15, Vino Veritas entered into a 45-day forward contract to purchase 375,000 euros. It properly designated the forward contract as a fair value hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency forward contract. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field. Round your present value interest factor to four decimal places. Round your answers to 2 decimal places.) |
c. | Vino Veritas ordered the wine on September 15, 2015. The wine arrived and the company paid for it on October 31, 2015. On September 15, Vino Veritas entered into a 45-day forward contract to purchase 375,000 euros. The company properly designated the forward contract as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured by referring to changes in the forward rate. Prepare journal entries to account for the foreign currency forward contract, firm commitment, and import purchase. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field. Round your present value interest factor to four decimal places. Round your answers to 2 decimal places.) |
d. | The wine arrived on September 15, 2015, and the company made payment on October 31, 2015. On September 15, Vino Veritas purchased a 45-day call option for 375,000 euros. It properly designated the option as a cash flow hedge of a foreign currency payable. Prepare journal entries to account for the import purchase and foreign currency option. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field. Round your present value interest factor to four decimal places.) |
e. | The company ordered the wine on September 15, 2015. It arrived on October 31, 2015, and the company made payment on that date. On September 15, Vino Veritas purchased a 45-day call option for 375,000 euros. It properly designated the option as a fair value hedge of a foreign currency firm commitment. The fair value of the firm commitment is measured by referring to changes in the spot rate. Prepare journal entries to account for the foreign currency option, firm commitment, and import purchase. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field. Round your present value interest factor to four decimal places. Round your answers to the nearest dollar amount.) |