Options, Swap (2011 June Q2)

1. When using the options, we know in advance how much will not be hedged (because of the fixed size contracts). If we do nothing else then that amount remains at risk, because that amount would have to be converted at whatever the spot rate happens to be in 4 months time.. A way of removing that risk will be to use the forward rate, which then fixed the exchange rate on this amount not covered by the options.

2. It is because the inflation rates given at yearly inflation rates. However we need it in six months time (i.e. in half a year)

3. The bank has offered to covert the income in MShs to Euros at fixed rates (instead of us having to convert at whatever the actual spot rate happens to be). The way they are fixing the rates is by calculating a forward rate (using interest rate parity formula). If we agree to this, then we will know exactly how many Euros we will receive. (If we don’t agree to it, then the Euro receipt could be higher or lower depending on what actually happens to the spot rates.)

You are welcome 🙂

With regard to the premium, because we are in EUR and the premium is calculated in $’s, we need to buy $’s to be able to pay it. Since it is a $/EUR quote, if we are buying $’s (the first mentioned currency) then it is the lower rate that applies (1.3585).
(If choosing the rate is causing the problem, then do watch my free lecture where I explain why and when each of the two rates is applicable).

With regard to the under-hedge, the point is that the options are in fixed sized contracts, and so we cannot deal in the exact amount of the transaction (which is what we would really want to do). Because of this, we know from the very start that there is a bit left over.
Either we do nothing about this, and that little bit is just left at risk. Or, if we want to remove the risk then we can used forward rates just on that bit (assuming in general that forward rates are available). It is not something to be too worried about, but it is a good point to be able to make in the exam.

You are welcome 🙂

Have you read my previous replies in this thread, because in them I have explained almost all of the answer to part (a).

I don’t understand you, because in part b we are not required to calculate an NPV.
Part b asks what loan finance will be required to undertake the project in 6 months.

I don’t understand where you are getting 120.87 from.

The question says that the swap will be at the estimated forward rates, and so the rates need to be calculated using the interest rate parity formula for 0.5 years, 1.5 years, 2.5 years, and 3.5 years.