Compute the break-even rate for the options hedge – Microeconomics
Raider Inc., an American importing firm anticipates an outflow of ¥893 million in 6 months. Raider’s management team is worried about the course of the ¥/$ exchange rate over the next 6 months and decides to hedge. The current spot and forward rates are S0=121 ¥/$ and Ft=6 months = 125 ¥/$. The $-interest rate is 5.56% and the ¥-interest rate is 0.48%.
a. Compute the $ cost to Raider Inc. if it hedges its position using the forward market.
b. Compute the $ cost to Raider Inc. if it hedges its position using the money market.
c. Which of the two above hedges is best for Raider Inc.?
d. Alternatively, Raider Inc. is contemplating the use of an options hedge. Sanwa bank is offering to Raider Inc. the following options: i. Call option on ¥893 million at K=121 ¥/$, with a 3.3% premium (price as a percent of current spot rate). ii. Put option on ¥893 million at K=121 ¥/$, with a 2.75% premium (price as a percent of current spot rate).
e. What is the cost of the option hedge? (Hint : show the cost for the worst case scenario)
f. Compute the break-even rate between the options hedge and the better one of the forward and money market hedges. How does the break-even rate help you decide on which hedge to use?
