Microsoft Word - Document1Question NATIONAL (UAE)’s trading cuency is Dirham (AED). Today, the...

Question

Microsoft Word - Document1Question  NATIONAL (UAE)’s trading cuency is Dirham (AED). Today, the company XYZ from the UAE placed a US$10,000,000 order to purchase a water purification system from Bruce Co, U.S.A.  This order is of significant size compared to the total budget of XYZ.  The delivery term is 4 months, and upon testing and certification, the company will make full payment 2 months later.   Today, RHB Bank (in the UAE) has offered the following quotes:  Spot rate          XXXXXXXXXX4.20 UAE / US$ 1-month forward rate XXXXXXXXXXUAE / US$ 6-month forward rate XXXXXXXXXXUAE / US$ 1-month UAE deposit rate  2.45% per year 1-month UAE boowing rate 4.45% per year 6-month UAE deposit rate 2.55% per year 6-month UAE boowing rate 4.75% per year 1-month US$ deposit rate  3.5% per year 1-month US$ boowing rate 5.5% per year 6-month US$ deposit rate 3.65% per year 6-month US$ boowing rate 5.85% per year 1-month at-the-money put option on 1 million USD at 1.5% premium 1-month at-the-money call option on 1 million USD at 1.5% premium 6-month at-the-money put option on 1 million USD at 2% premium 6-month at-the-money call option on 1 million USD at 2% premium   Required: Discuss the risk of staying unhedged. Compare at least three different hedging strategies and recommend which one the company should adopt if the forward rate is a good prediction of the future rate in 6 months. Show your workings clearly. Conclude which strategy is the best if the spot rate in 6 months is 4 UAE/US$.  You may illustrate your findings with a diagram (ideally a graph in excel or a picture taken with your phone that you insert in a Word file for instance).  Bonus: Explain how you would change your solution if instead of one exchange rate, you were given a bid-ask spread for the exchange rate.  Spot rate         XXXXXXXXXXBID = 4.19 UAE / US$ - ASK= 4.20 UAE / US$ 1-month forward rate XXXXXXXXXXBID = 4.20 UAE / US$ - ASK= 4.22 UAE / US$ 6-month forward rate XXXXXXXXXXBID = 4.21 UAE / US$ - ASK= 4.23 UAE / US$

Himanshu · Accepted Answer

Staying unhedged entails taking unrewarded risk. A full hedge might be costly.... The difference in aggregate yields between the base currency and the foreign currencies (that is the expected cost, or negative returns, of hedging) Hedging is usually a good idea, but the individual investor must decide which type of hedging is ideal, particularly when it comes to puts, calls, and short selling. However, every investor should at the very least practise the fundamentals of hedging, which include basic diversification. Hedging against investment risk entails utilising financial instruments or market tactics to mitigate the risk of adverse price changes. To put it another way, investors hedge one investment by trading in another. A reduction in risk, therefore, always means a reduction in potential profits.
When investing internationally, exchange rate risk cannot be completely avoided, but it may be significantly reduced via the use of hedging measures. Investing in hedged investments, such as hedged ETFs, is the simplest approach.
Depending on the asset or portfolio of assets being hedged, there are a variety of successful hedging options available to decrease market risk.
1. Short hedges: Short hedges are often launched by traders who hold an asset and are afraid that prices may fall before the sell date.
To illustrate a short hedge consider a grain elevator operator who is in the business of purchasing and storing grain for future sale. As an example, reconsider the previous corn problem where S(0) = $2.06, F(0) = $2.15, the delivery date is 3 months away, and the basis is predicted to be fairly stable over the next 3 months, increasing at a rate of 3 cents per month. If the grain elevator planned on selling its corn in 3 months time, it could eliminate all price uncertainty by selling futures contracts to lock in a specific price. The sale of futures contracts against an inventory of the underlying commodity would then be a perfect hedge. However, in this example, we shall assume that the sales date is in 2 months time, a full month earlier than the settlement date. To lock into a sales price for corn, the grain elevator sells a futures contract. After 2 months the grain elevator offsets the transaction in the futures market and sells the corn as planned.

Microsoft Word - Document1 Question NATIONAL (UAE)’s trading currency is Dirham (AED). Today, the company XYZ from the UAE placed a US$10,000,000 order to purchase a water purification system from...

Solution

Answer To This Question Is Available To Download

Related Questions & Answers

Submit New Assignment