In: Accounting
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)
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.