Question

Cisco (CSCO) has $5 billion worth of profit from European operations in 2018. The company plans to bring back the profits back into the US in 12 months. The current exchange rate between USD and Euro was $1.105 at the time of the deal. The exchange rate forecast was for Euro to depreciate against the USD, but the exact decline is not known. CSCO decided to hedge with derivatives and purchased enough options for USD. The call option with strike price of $1.08 per Euro is selling for the price of $0.005 USD. The put option with strike price of $1.08 is selling for $0.01. Which option should CSCO use? What is the profit/loss from the hedge if the exchange rate turns out to be $1.065 in 12 months? What about if the rate is $1.105?

Answer 1

The equivalent value of $5 billion in euro at current exchange rate is $5,000,000,000/$1.105 = euro 4,524,886,877.83.

so if exchange rate after 12 months is below $1.105/euro then firm will have lower dollar profit than $5 billion.

CSCO use a put option to hedge the future exchange rate risk of lower than current exchange rate of $1.105. A put option gives a right but not an obligation to sell the currency at strike price at the expiration of the option.

Profit from the hedge if the exchange rate turns out to be $1.065 in 12 months

Profit = euro 4,524,886,877.83*($1.08 - $1.065 - $0.01) = euro 4,524,886,877.83*$0.005 = $22,624,434.39

if the rate is $1.105 then CSCO will let the option expire worthless because euro amount can be converted using higher spot rate in $ instead of lower strike rate of option. the only loss from hedge will be option premium paid to purchase the put option.

loss = euro 4,524,886,877.83*$0.01 = $45,248,868.78