Question

Najafi Company. Najafi​ Company, U.S.-based manufacturer of industrial​ equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was 8,300

million Korean won​ (KRW). KRW1,000 million has already been​ paid, and the remaining KRW7,300
million is due in six months. The current spot rate is KRW1,114=​USD1.00,
and the​ 6-month forward rate is KRW1,177=USD1.00.
The​ 6-month Korean won interest rate is 15.5%
per​ annum, the​ 6-month U.S. dollar rate is 3.5​%
per annum. Najafi can invest at these interest​ rates, or borrow at 2%
per annum above those rates. A​ 6-month call option on won with a KRW1,200=USD1.00
strike rate has a 3.3​%
​premium, while the​ 6-month put option at the same strike rate has a 2.6​%
premium.​ Najafi's weighted average cost of capital is 10.5​%.
Compare alternate ways below that Najafi might deal with its foreign exchange exposure.
a. How much in U.S. dollars will Najafi pay in 6 months without a hedge if the expected spot rate in 6 months is assumed to be KRW1,114=​USD1.00?
KRW1,177=​USD1.00?
b. How much in U.S. dollars will Najafi pay in 6 months with a forward market​ hedge?
c. How much in U.S. dollars will Najafi pay in 6 months with a money market​ hedge?
d. How much in U.S. dollars will Najafi pay in 6 months with an option hedge if the expected spot rate in 6 months is assumed to be less than KRW1,200=​USD1.00?
To be KRW1,300=​USD1.00?
e. What do you​ recommend?

Answer 1

Najafi Company can manage its foreign exchange risk through various hedging strategies. The cost of these strategies will depend on the future spot rate and include no hedge, forward market hedge, money market hedge, and option hedge.

Step-by-step explanation:

Assessment of Hedging Strategies for Najafi Company

When assessing Najafi Company's options for managing their foreign exchange exposure, we must analyze the cost implications of different hedging strategies. Here's how to calculate the cost in U.S. dollars for each scenario:

1. No Hedge: Without a hedge, if the spot rate in 6 months remains at KRW1,114=USD1.00, Najafi would pay 7300 million / 1114 = $6.55 million. If the rate is KRW1,177=USD1.00, the payment would be 7300 million / 1177 = $6.2 million.
2. Forward Market Hedge: With a forward rate of KRW1,177=USD1.00, the cost would be 7300 million / 1177 = $6.2 million.
3. Money Market Hedge: Borrow the present value of KRW7,300 million at the Korean rate and convert to USD at the current spot rate. Then invest the USD at the U.S. rate for 6 months to pay off the hedge. The calculation factors interest rates and compounding.
4. Option Hedge: Buying a call option, if the expected rate is less than KRW1,200=USD1.00, the cost includes the premium paid. If the spot rate is KRW1,300=USD1.00, Najafi can exercise the option at a lower rate and pay the strike price plus the premium.

Each strategy comes with its risks and potential costs, and the choice depends on Najafi's risk tolerance, market expectations, and cost considerations.