Question

Boeing imported a Rolls-Royce jet engine for £5 mil payable in one year
• The US interest rate 6.00% per annum
• The UK interest rate 6.50% per annum
• The Spot exchange rate $ 1.80/£ today
A. The company decides to use options to hedge the risk of pound exchange one year later. What kind of options should the company buy? Put or Call?

B. Assume the strike price of the option is $1.82/£ with a premium of $.02/£ paid today. What is the dollar cost one year later if the spot rate then is 1.60, 1.80 and 2.00 respectively?
C. How could Boeing use money market to hedge the risk? Please provide all details (7 points)

Answer 1

A. Boeing has a payable of £5 million after one year. So we must but Call options on £

B. If the strike price is $1.82/£. The premium is $0.02/£.

Computing dollar cost for company after 1 year (not considering premium paid now)

1. If the spot rate then is 1.6

If the rate is $1.6/£, we will not exercise the call option. So the dollar cost is £5 million x $1.6/£ = $8 million

2. If the rate is $1.8/£, we will not exercise the call option. This will make the dollar cost is £5 million x $1.8/£ = $9 million

3. If the rate is $2.0/£, we will exercise the call option with strike price $1.82/£. This will make the dollar cost is £5 million x $1.82/£ = $9.1 million

C. Money market hedge

Amount payable after one year £5 million

Interest rate in UK is 6.5%

Present value amount to receive £5 million after 1 year

Amount to deposit = £5 million/(1+0.065) = £4,694,836

In $ terms = £4,694,836 x spot rate= £4,694,836 x $1.8/£ = $8,450,705

Strategy :

1. Borrow $8,450,705 now in US at 6%

2. Convert this amount into £ at spot rate of $1.8/£, we will receive £4,694,836

3. Deposit this £4,694,836 in UK at 6.5%

4. On due date, receieve the deposit with interest an amount of £5 million and use this to pay the supplier

5. In US, the borrowed amount will be paid along with interest of $507,042. Total repayment will be $8,957,747.

Outflow will be $8,957,747

This strategy will help in fixing the outflow at the start of year.