Question

XYZ ltd. has imported raw material of Euro 14 million from Germany with the credit of 30 days. The finance officer of XYZ ltd. wants to hedge this transaction for foreign exchange risk exposure. The prevailing interest and exchange rates in the markets are: Spot Rate: Euro 80.49/ INR Forward Rate: Euro 80.79/ INR 30 day Put Option on INR EURO 0.012/ Euro at 1% premium 30-day Call option on INR EURO 0.024/ Euro at 1 % premium EURO interest rate: 7% INR interest rate: 14% Based on the above data, answer the following questions: a:Explain different hedging options available to XYZ ltd? b. What is the hedged cost of XYZ ltd payable using forward market hedge, put option hedge and money market hedge? (5 Marks) **

Answer 1

XYZ ltd. has three hedging options available to manage their foreign exchange risk exposure: forward market hedge, put option hedge, and money market hedge. The cost of hedging for XYZ ltd. varies depending on the option chosen.

Step-by-step explanation:

XYZ ltd. has several hedging options available to manage their foreign exchange risk exposure:

1. Forward Market Hedge: They can enter into a forward contract to buy euros at a predetermined exchange rate. This will protect them from any adverse changes in the exchange rate.
2. Put Option Hedge: They can purchase a put option on the INR. This gives them the right, but not the obligation, to sell euros at a specified exchange rate. If the exchange rate falls, they can exercise the option and sell euros at a higher rate.
3. Money Market Hedge: They can borrow funds in euros to pay for the imported raw material. This reduces their foreign exchange risk exposure as they will not be affected by changes in the exchange rate.

The cost of hedging for XYZ ltd. using the different options is as follows:

1. Forward Market Hedge: The hedged cost payable is Euro 14 million x forward rate (Euro 80.79/INR) = INR 1,135.06 million.
2. Put Option Hedge: The hedged cost payable is Euro 14 million x put option premium (Euro 0.012/Euro) = Euro 168,000.
3. Money Market Hedge: The hedged cost payable is the amount borrowed in euros.