5. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U. S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of. 014 cents per yen. (a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges. (b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used. (c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge? (Hint: Compute the highest possible cost of using the option hedging, and compare it with the cost of using the forward hedging.)

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.