Answer:
a.) $4,147,465
b.)The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.
Explanation:
(a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)
= $4,147,465.
(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) = $75,600.
At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).
The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.
(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.
