Question

Dell Corp. sold a computer system to a customer in the UK and billed £10 million receivable in 6 months. Dell would like to control for the exchange rate risk. The current spot exchange rate is $1.30/£ and the 6-month forward exchange rate is $1.27/£ at the moment. Dell can buy a 6-month put option on £10 million with a strike price of $1.32/£ for a premium of $0.02 per pound. It can also buy a 6-month call option on £10 million with a strike price of $1.29/£ for a premium of $0.15 per pound. Currently, 6-month interest rate is 6.1% per annum in the U.K. and 5.0% per annum in the U.S.

a) Compute the guaranteed dollar proceeds from the sale if Dell decides to hedge using a forward contract.

b) If Dell decides to hedge using money market instruments, what action does Dell need to take? What would be the guaranteed dollar proceeds from the sale in this case?

c) If Dell decides to hedge using options on pounds, what option (put or call) will Dell use? And what would be the ‘expected’ dollar proceeds from the aircraft sale? Assume that Dell regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

d) Based on the available information and your calculations above, what is your recommendation to Dell for a best strategy (forward hedge vs money market hedge vs options hedge)? Why?

e) Other things being equal, at what forward rate would Dell be indifferent between the forward and money market hedge?

Answer 1

a)FORWARD MARKET:

Forward rate:$1.27/£

Enter into a forward contract to SELL £ 10,000,000

Guaranteed dollar proceeds after 6 months =$1.27*10000000= $12,700,000

b) MONEY MARKET HEDGE:

Strategy:

1.Borrow Present Value of £ 10,000,000 at 6.1% interest rate in UK

6 months interest =(6.1/2)%=3.05%=0.0305

Present Value =10000000/(1+0.0305)= £ 9,704,027

Borrow £ 9,704,027

2. Convert into US dollar at current spot exchange rate: :$1.30/£

Receive 9704027*1.30=$12,615,235

3. After 6 months pay back borrowed amount with interest (total £ 10,000,000) from the amount received

Guaranteed dollar proceeds today=$12,615,235

Invest this amount in US at 5% per annum

Six month’s interest =(5/2)%=2.5%=0.025

Guaranteed dollar proceeds after 6 months=$12,615,235*1.025=$12,930,616

c) If the rate rate decreases, there is risk of loss . To hedge the risk, Dell should buy PUT option

Expected dollar proceeds if the spot rate is:$1.27/£ after 6 months:

1.Dollar proceeds from conversion at spot rate =10000000*1.27== $12,700,000

2. Payoff from Put Option =(1.32-1.27)*10000000=$500,000

3.Cost of Put Option =10000000*$0.02=$200,000

Net Proceeds=12700000+500000-200000=$13,000,000

d)Recommendation: Use PUT option , it gives maximum dollar proceeds