Question

Suppose Boeing Corporation exported a Boeing 787 to British Airway and billed £20 million payable in one year (i.e., Boeing has a £20 million receivable in one-year). The money market rates, foreign exchange rates, and option prices are given as follows:

The U.S. one-year interest rate: 2% per annum

The U.K. one-year interest rate: 3.5% per annum

The spot exchange rate: $1.32/£

One-year forward rate: $1.2985/£

Call option: exercise rate: $1.31, premium: $0.015/£

Put option: exercise rate: $1.31, premium: $0.02/£

(1) Money Market Hedge: Show money market hedge strategy (i.e., through borrowing/lending) that Boeing can use to hedge this transaction exposure. Be sure to include the following.

(a)State which currency Boeing should borrow and calculate how much it should borrow.

(b) State the transactions needed to be done and the cash flows at t=0 and t=12 (i.e., today and one-year from today) by constructing a cash flow table.

(2) Option Market Hedge:

(a) Should Boeing use a Call or a Put to hedge this exposure?

(b) How much net USD will Boeing receive with an option hedge?

(3) Suppose Boeing’s analyst predicts that the exchange rate between USD and UK pound in 1 year is between $1.32/£ and $1.33/£. (To receive full credit, you need to answer the questions qualitatively and quantitatively.)

1. At which exchange rate will Boeing be indifferent between Money Market Hedge and Option Market Hedge?
2. If the analyst’s prediction is correct, among the Forward Market Hedge, Money Market Hedge, and Option Market Hedge, which one is preferable and why?

Answer 1

Assumption :

In the lack of information about the exchange rate after 1 year, it is assumed that the option ends "In the Money"
and hence exercised.