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...

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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 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 borrowing rate 4.45% per year
6-month UAE deposit rate 2.55% per year
6-month UAE borrowing rate 4.75% per year
1-month US$ deposit rate 3.5% per year
1-month US$ borrowing rate 5.5% per year
6-month US$ deposit rate 3.65% per year
6-month US$ borrowing 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$
Answered Same DayMay 16, 2021

Solution

Himanshu Sangail answered on May 17 2021
21 Votes

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...

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