Cirque du Cochon Winter 2010 First Case with Solution Page 1 of 6

International Financial Management

Dr. J. A. Schnabel

First Case: Cirque du Cochon, S.A. with Solution

Part I. Cirque du Cochon, S.A. is a Belgian chain of haute cuisine restaurants that
specializes in pork delicacies. Cirque expects to receive, eight months from now, a
remittance of AUD 15 million from its Australian franchisee, Pigs Fair Dinkum Ltd.
(AUD denotes the Australian dollar and EUR, the euro.) Cirque is considering a hedge
for this exposure.

Banque de Belgique has quoted Cirque the following exchange rates:

In AUDs per EUR Bid Ask

Spot AUD1.72 AUD 1.74
8-month Forward AUD 1.69 AUD 1.71

The following continuously compounded interest rates are likewise quoted to Cirque:

Currency Deposit Rate Borrowing Rate

EUR 2.7% 3.1%
AUD 2.4% 2.6%

Assuming a common exercise price of Euro 0.58 per AUD, the following option premia
have been quoted to Cirque:

In EURs per AUD Bid Ask

Call option EUR 0.036 EUR 0.042
Put option EUR 0.035 EUR 0.039

A.) (30%) Detail the transactions required to construct the appropriate money market
hedge and the appropriate option collar hedge, citing dates and transaction
amounts. Note that the phrase “transaction amount” means that answers given per
unit of the foreign currency are not sufficient. Decide on the best forward hedge
via a comparison of outright and synthesized forward rates. Compare your
chosen forward hedge with the appropriate option hedge by calculating the
breakeven point. Explain the implications of this breakeven point as regards the
choice between a forward hedge versus an option hedge. In short, apply the
hedging protocol to Cirque’s foreign currency receivable.

B.) (30%) Answer part A.) but this time assume that Cirque projects a payable, rather
than a receivable, likewise amounting to AUD15 million.
Cirque du Cochon Winter 2010 First Case with Solution Page 2 of 6

Part II. Cirque also projects receiving NZD 3 million a year from now, where NZD
denotes the New Zealand dollar.

The following exchange rates, expressed in terms of NZDs per EUR, are provided by
HSBC.

In NZDs per EUR Bid or Ask

Spot 2.02
1-year Forward 2.24

The following interest rates, quoted as continuously compounded rates, are likewise
provided by HSBC for one-year maturity deposits and loans.

Currency Deposit or Borrowing Rate

EUR 3%
NZD 6%

The volatility or standard deviation of the NZD with respect to the EUR is estimated to
equal 25%.

C.) (20%) If Cirque specifies a contractual forward rate of NZD 2.10 per EUR to
hedge its NZD exposure, decide on the amount of up-front payment in EURs for
the forward contract and determine who should pay whom, i.e., does Cirque pay
HSBC or does HSBC pay Cirque? Answer the same question, this time assuming
a contractual forward rate of NZD 2.5 per EUR.

D.) (20%) HSBC had offered Cirque a range forward that is denominated in EURs
with an upper limit of EUR 0.51 per NZD and a lower limit of EUR 0.38 per
NZD. Employing both forward and spot rate versions of the Black-Scholes model
for valuing foreign exchange options, decide whether this range forward is
correctly valued, overvalued, or undervalued. If the range forward is not correctly
valued, determine the EUR-amount by which the range forward is overvalued or
undervalued. Employ the numa.com calculator, detailing the numerical values of
the required parameters, i.e., “stock price, “dividend yield,” etc.
Cirque du Cochon Winter 2010 First Case with Solution Page 3 of 6

Solution of: Cirque du Cochon, S. A.

(Points allocation indicated in italicized parentheses.)

Note that, due to rounding, some of the following quantitative assertions may not
hold exactly.

Part I.
A.) The exchange rates are given in the case in the form of indirect quotation. They
are restated as follows.

In EURs per AUD Bid Ask

Spot (1/1.74) = 0.5747 (1/1.72) = 0.5814
8-Month Forward (1/1.71) = 0.5848 (1/1.69) = 0.5917

To hedge the AUD receivable, we may either sell the AUD forward or buy a put on the
AUD.

With regard to selling the A$ forward, three alternatives are considered.

Employ an outright forward at a rate of EUR 0.5848.

A money market hedge may be constructed involving the following three steps. Borrow
AUDs at an interest rate of 2.6%, sell AUDs on the spot market at a rate of EUR 0.5747,
then invest in EURs at a rate of 2.7% for the eight month period.

FMMH = (0.5747)e ( 2.7% − 2.6%).6667 = 0.5751

As the “sell high” rule is operative here, the money market hedge is deemed inferior to
the outright forward.

MMH Transactions (10%):

Now:
Borrow AUDs = AUD 15M e^(-2.6%)(.6667) = AUD 14.742M
Sell AUDs spot, obtaining AUD 14.742M (.5747) = EUR 8.472 M
Deposit EURs at 2.7%

After 8 months:
Close out EUR deposit, obtaining EUR 8.472 M e^(2.7%)(.6667) =EUR 8.6259 = AUD
15 M (EUR 0.5751/AUD).
Pay back AUD loan, paying AUD 14.742 e^(2.6%)(.6667) = AUD 15 M with AUD
receivable.

A second way of synthesizing a forward sale is via an option collar, viz., buy a put and
sell a call at the given exercise price of E0.58. As the call premium of E0.036 is less than
Cirque du Cochon Winter 2010 First Case with Solution Page 4 of 6

the put premium of 0.039, the initial cash flow of this option collar is negative. This
implies that the Euro borrowing rate of 3.1% must be employed.

FOC = (0.036 − 0.039)e 3.1% x ,6667 + 0.58 = 0.5769

As this synthesized forward rate is less then the outright forward rate, the outright
forward is deemed the best of the three possible forward hedges.

(5% Calculation of 3 forward rates and decision regarding the best forward hedge.)

OC Transactions (10%):

Now:
But put -.039(AUD 15 M)
Sell call .036(AUD 15 M)
Finance EUR 0.045 M initial outlay at 3.1%.

After 8 months:
Receive .58(AUD 15 M) = EUR 8.7 M and deliver AUD 15 M, employing the AUD
receivable.
Pay off EUR loan, paying EUR .045 e^3.1%(.6667) = EUR .04594
The net amount received = EUR 8.654 M = AUD 15 M(.5769)

The second step of the hedging protocol involves comparing the outright forward sale
with the purchase of a put option. This necessitates a breakeven calculation, the future
spot rate at which both hedges generate the same cash flow. This breakeven future spot
rate equals the sum of the outright forward rate and the future value of the put premium.
The future value calculation requires the use of the EUR borrowing rate of 3.1% as the
put premium must be financed.

B = 0.5848 + 0.039e 3.1% x.6667 = 0.6246

For future (i.e., 8 months from now) spot rates above EUR 0.6246 the put is superior
whereas for rates below EUR 0.6246 the outright forward sale is superior. The choice
between buy put and outright forward sale depends on which of these events is the more
probable.

(5% Calculation of breakeven point and discussion of implications thereof.)

B.) Hedge AUD 15 M payable via buy forward (outright, MMH, OC) versus buy a call.

Outright F = .5917

FMMH = .5814e ( 3.1% − 2.4%).6667 = .5841

FOC = .58 + (.042 − .035)e (3.1%).6667 = .587
Cirque du Cochon Winter 2010 First Case with Solution Page 5 of 6

Since the buy low rule is operative, the best forward hedge is the MMH.

(5% Calculation of 3 forward rates and decision regarding the best forward hedge.)

MMH Transactions (10%):

Now:
Borrow EURs = .5814 (AUD 15 M) e^(-2.4%).6667 = EUR 8.5826 M
Buy AUDs spot, obtaining AUD 8.5826 M/.5814 = AUD 14.762 M
Deposit AUDs at 2.4%

After 8 months:
Close out AUD deposit, obtaining 14.762 M e^(2.4%).6667 = AUD 15 M. Employ this
to pay the AUD liability.
Pay off the EUR loan, paying EUR 8.5826 e^(3.1%).6667 = EUR 8.762 = AUD 15 M
(.5841).

OC Transactions (10%):

Now:
Buy call -.0452(AUD 15 M)
Sell put .035(AUD 15 M)
Finance the EUR.105 initial outlay at 3.1%.

After 8 months:
Pay .58(AUD 15 M) = EUR 8.7 M and receive AUD 15 M. Use latter to satisfy the AUD
payable.
Pay off EUR loan, paying EUR .105 M e^(3.1%).6667 = EUR .1072 M
Total amount paid = EUR 8.8072 = AUD 15 M (.587)

The second step of the hedging protocol involves comparing the best forward hedge, i.e.,
MMH, with buy a call via a breakeven calculation.

B = 0.5841 − 0.042e 3.1% x.6667 = 0.541

Define S as the spot rate 8 months hence quoted in terms of (EUR/AUD). For S < .541,
buy a call is best. For S > .541, construct a money market hedge is best. The choice
between the two alternatives depends on the more probable of these two events.

(5% Calculation of breakeven point and discussion of implications thereof.)

Part II.

C.) The data provided must be restated in the form of direct quotation, as follows.
Cirque du Cochon Winter 2010 First Case with Solution Page 6 of 6

S = 1/2.02 = EUR .495

F = 1/2.24 = EUR .446

For the contractual forward rate of 1/2.1 = EUR .4762, the value of Sell forward is given
as V in the following calculation. Thus, Cirque must pay HSBC EUR 87,900 at
inception.
V = (.4762 − .446) NZD3Me −3% = EUR.0879M = EUR87,900

For the contractual forward rate of 1/2.5 = EUR .4, the value of Sell forward is given as
V in the following calculation. Thus, Cirque must receive from HSBC EUR 133,900 at
inception.

V = (.4 − .446) NZD3Me −3% = − EUR.1339M = − EUR133,900

(10% for each of the two payment calculations.)

D.) Cirque must sell a Range Forward to hedge the NZD receivable. Thus, the value of
the Range Forward equals P(L=.38) minus C(U=.51).

The parameter inputs for both versions of the Black-Scholes model are as follows.

Forward Rate Version Spot Rate Version

Stock price 0.446 0.495
Interest rate 3% 3%
Dividend yield 3% 6%
Time to expiry 1 1
Volatility 25% 25%
Exercise price of Call 0.51 0.51
Call premium .021 .035
Exercise price of Put 0.38 0.38
Put premium .016 0.01
Value of Range Forward -EUR 15,000 -EUR 75,000

The Value of the Range Forward equals (Put premium minus Call premium) multiplied
by NZD 3 M.

Both versions state that the Range Forward is overvalued. The Forward Rate version
states that the Range Forward is overvalued by EUR 15,000. The Spot Rate version
states that the Range Forward is overvalued by EUR 75,000.

(10% for each of the two valuation applications.)