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Solution of IFM

Different Hedging used by Singapore Airlines

  1. If Singapore Airlines want to long or short

The total amount billed by Airbus is € 500 million to Singapore airlines which will be payable in one year.

The current spot rate is SGD 1.58 per Euro.

The one-year forward rate is SGD 1.62 per Euro.

If Singapore airlines will have to go for a long Forward contract as it has paid to Airbus.

Hence if it goes for a forward contract than the amount payable will be

= € 500 millions x 1.62 = SGD 810 millions .

The annual interest rate is 3.5% in the Euro Zone as well as 5 % in Singapore.

As per the money market, hedge Singapore Airlines will take a loan from Singapore bank and investing in eurozone banks and repay the airbus in one year. the present value of the € amount for repayment amount if deposited in Eurozone banks.

= € 500 / 1.035 = € 483.09 millions

This amount will be converted in to SGD at spot rate = € 483.09 millions x 1.58 = SGD 763.28 millions .

If Singapore Airlines takes this amount as a loan from the bank than they have to pay in one year time = SGD 763.28 million x 1.05 = SGD 801.45 million.

Hence if the Singapore airlines future cost in different alternatives is as follows

  1. Forward Contract = SGD 810 millions
  2. In the money market hedge = SGD 801.45 million

Hence the Singapore airlines should hedge through the money market hedging.

b). Singapore airlines can hedge by option also. Singapore airlines can also buy a one-year call option on euro at the strike price of € 0.601 per SGD at a premium of 0.14 cents per euro. the expected spot rate in one year is SGD 1.63 per euro.

When Singapore airlines book a call option the rate of the call option is SGD 1.664 per EURO.

Total option premium payable by the SGD = 500 x 0.14/100 = 0.7 milion EURO

If the company buys a call option than the option rate is SGD 1.664 per EURO hence the company will cancel the option and buy from the spot market.

The total amount of out flows under the call option

= 500 x 1.63 = SGD 815 million + 0.7 x 1.63 = 815 + 1.41 = SGD 816.41 millions

  1. When the expected spot rate in the one year time is SGD 1.63 per euro

In this situation the payment as per forward contract will be

= 500 x 1.63 = SGD 815 million Euro

Payment will be as per the option = SGD 816.41 million

Hence in this situation, Singapore airlines will prefer to go for a forward contract for hedging rather than go for option hedging.

Q no. 4 :

City research in the US Company

The cost of the project is € 5,500,000 in Germany and it will take one year to complete.

But the amount financed by the bond is only $ 2,900,000 as the rest of the amount is finance by the equity.

The currency exchange rate is expected to be

€ 0.7519 per one $.

Hence bond required in the Germany = $ 2,900,000 x 0.7519 = € 2,180,510

Bond amount can be financed by city research US company = $ 2,900,000 @ 8 % in the USA market or it can borrow € 2,180,510 in the Euro market @ 7%.

The Max planc Institiute Germany can borrow € 2,180,510 in the Euro market @ 6% or it can borrow $ 2,900,000 @ 9 % in the USA market.

Interest payments = $ 2,900,000 x 8% = $ 232,000 in the USA

Interest payment exposure in Germany = € 2,180,510 x 6% = € 130,831

Contractual exchange rates : € 130,831 / $ 232,000 = 0.564 € per Dollar

Maturity exchange rates = € 0.7519 per $

Hence they will do the agreement and SWAP the bond as it is cheaper to borrow in their home country.

a). Yes, it is mutually beneficial that they can have a swap agreement and it will reduce /the rate of interest of bond financing by 1% p.a. in their respective country.

  1. b)

    City research in the US will borrow $ 2,900,000 in the USA and give it to the subsidiary of the Max plance institute Germany in USA

  2. The Max Plance Institute Germany will borrow € 2,180,510 in the Euro market @ 6% and give it to sunsidiary of City research USA in Germany

On maturity, the reverse process will be followed and they will repay their bonds in their respective country.

c)

Principle sum payment and repayment is as same above and the city research in the US will pay

€ 130,831 interest p.a. for 7 years to The Max Pance Institute Germany which intern will pay to its bankers and the Max Plance institute Germany will pay $ 232,000 for interest to City research USA which intern will pay to their banker for 7 years.

d)

Interest conversion rate as the euro is appreciating 1% every year

Year

$

1

0.564

1

2

0.56964

1

3

0.575336

1

4

0.58109

1

5

0.586901

1

6

0.59277

1

7

0.598697

1

8

0.604684

1

Expoure of interest payments

Interest payment at

 

 

$

1

130848

2,32,000

2

132156.5

2,32,000

3

133478

2,32,000

4

134812.8

2,32,000

5

136161

2,32,000

6

137522.6

2,32,000

7

138897.8

2,32,000

8

140286.8

2,32,000

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