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Question 3c

Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise.

Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise.

Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows:

Year 1 2 3
Eurozone 6% 4% 3%
Wirtonia 3% 8% 11%

Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap.

Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees.

Relevant borrowing rates are:

Buryecs Co Counterparty
Eurozone 4·0% 5·8%
Wirtonia Wirtonia bank rate Wirtonia bank rate
+ 0·6% + 0·4%

In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank.

The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at today’s spot rate.

Exercise price Call options Put options
7·75 2·8% 1·6%
7·25 1·8% 2·7%

Assume a discount rate of 14%.

Required:
(c) Calculate the results of hedging the receipt of $7,500 million using the currency options and discuss whether currency options would be a better method of hedging this receipt than a currency swap. (7 marks)