Hedging Strategies and Market Risks

This assignment contains four parts, each focusing on a different aspect of finance. Part 1 involves hedging exchange rate risk by plotting profits from exporting mushrooms from Estonia to the UK as a function of exchange rates. It also explores setting up a forward hedge. Part 2 discusses financial options, specifically selling an August put and buying an August call for stock XYZ. The value and profit of this strategy are examined. Part 3 considers hedging exchange rate risk by deciding whether to buy a forward contract or invest in dollars today to pay for an apartment in Moscow. The present value cost is calculated. Finally, Part 4 involves calculating the current market value of debt and equity, as well as estimating the cost of capital for Hugo Boss AG.

1. (Hedging) You are a sales representative of an Estonian trading company that exports mushrooms to United Kingdom.
Under the terms of the contract, in one year you will deliver 80 tons (=80 000kg) of mushrooms for 2.8 pounds a
kilogram. Your cost of obtaining mushrooms from the mushroom pickers from Võrumaa County is 3.40 EUR per kilogram.
You may assume that all cash flows occur in exactly one year.
a. Plot (in a graph) your profits in euros from the contract as a function of the exchange rate in one year, for exchange
rates from 0.50 EUR/GBP to 0.80 EUR/GBP (with increments of 0.10 euros). Label this line “Unhedged Profits”.
Explain carefully the exposure to exchange rate risk.
b. Suppose that the current one-year forward exchange rate is 0.7 EUR/GBP and you consider setting up a forward
hedge. Please explain how exactly would you set up the hedge and plot your combined profits from the contract and
the forward contract as a function of the exchange rate in one year. Label this line “Forward Hedge”.
c. Compare and explain your result from b. with the result from a.
3- (financial options) The stock currently trades at $40 in June. An option trader considers the following strategy concerning the
stock XYZ. Trader sells one AUG 38 put for $1 and buys a AUG 42 call for 1$. Please construct a figure that depicts the value of
the strategy and the profit at expiration. You may look at the stock price range btw $35-45. Please discuss also, what are the
expectations of the trader about the future price of the stock? What are the main risks involved?
4---(hedging exchange rate risk)The current level of real estate prices in Moscow seem to be on a reasonable level now and you
consider that this is just the right time to step into the market. You have noticed a nice apartment in the Leninsky Prospekt close
to the city centre. The price for the apartment is $1.46 million. However, due to tax reasons you could buy that apartment only
after 6 months. Currently you have sufficient funds deposited in a bank in Cypros (in euros). The annual yield on a bank deposit is
2.8%. Another option would be to convert a certain amount into dollars and deposit these funds into another bank with the
annual yield of 1.6%. The spot exchange rate is 1.0606 EUR/USD (see the quote conventions from the lecture slides) and the 6m
forward rate is quoted with discount equal to -84 basis points.
two options of how to pay for the apartment:
a) Buy a forward contract for buying dollars against euros in six months (and continue to deposit euros)
b) Invest enough dollars for dollar deposit already today.
Questions:
* Try to show with calculations, which option has the lowest present value cost for you in euros?
* Compute the correct forward rate implied by the interest rates.
BONUS PROBLEM
Hugo Boss AG is a German luxury fashion and style house that is examining its financing policy for possible changes. The firm has
8-year coupon bonds outstanding with a face value of $ 400 million and interest expenses of $18.0 million a year. This is the only
debt obligation, the company has. The firm is rated BB and the default spread (on top of risk free rate) for BB rated bonds is 4%.
There are 20 million shares trading at $10 a share and the current levered beta for the firm is 1.80. The risk-free rate is 3% and
the market risk premium is 6%. The corporate tax rate for the firm is 40%.
Questions:
a. Estimate the current market value of debt and equity today.
b. Estimate the current cost of capital for the firm.
c. The company believes that it could lower it’s cost of capital by moving to debt to capital (D/A) ratio of 50%. The company
predicts that this move could lower it’s pre-tax cost of capital by 1.5 percentage points. Calculate the new cost of capital for the
company given that the change in capital structure is undertaken (note that you’ll have to unlever and relever your equity beta
to find the final answer).