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In: Finance

New Tech Corporation is based in Warwick, U.K. The Corporation will sell a network monitoring system...

New Tech Corporation is based in Warwick, U.K. The Corporation will sell a network monitoring system to Open Telecom Group. The system costs US$50,000,000 and will be paid by Open Telecom Group in six-months. New Tech Corporation plans to control any exchange rate risk incurred from this transaction. To hedge the exchange rate risk, New Tech Corporation buys a six-month put option on US dollars, with a strike price £0.80/US$ for a premium of £0.06/US$. At the moment, the spot exchange rate is US$1.3220/£ and the six-month forward rate is US$1.5235/£. Assume the six-month effective interest rate in U.K. is 0.5% per annum and in U.S. is 1.5% per annum.

(a) If New Tech Corporation uses money market instruments to hedge exchange rate risk, elaborate how the Corporation implement and assess the sterling proceeds incurred.

(b) New Tech Corporation treats the forward exchange rate as an unbiased predictor of the future spot exchange rate, what would be the proceeds this time with using put options on US dollars?

(c) Jeff is the financial manager of New Tech Corporation, he stated that there will be no difference between the option and money market hedge for the corporation. Explain and analyze Jeff’s belief. Provide any necessary calculation

Solutions

Expert Solution

(a) Money Market Hedge
US interest rate 1.50%
Six months interest=(1.5/2)=0.75%= 0.0075
Amount receivable after 6 months $50,000,000
Present Value of receivable $49,627,792 (50000000/(1+0.0075)
New Tech will borrow $49,627792 in US
Current spot exchange rate 1.3220US$/Pound
Convert US dollar borrowed to Pound at spot rate
Amount available after conversion £        37,539,933 (49627792/1.322)
Invest the amount in UK at interest rate 0.5% pa
Amount available after six months=37539933*(1+(0.005/2) £        37,633,783
(b) Hedging through Put Option
Strike Price=Pounf 0.80/US$
Premium paid=Pound 0.06/US dollar
Settlement rate after six months=US$1.5235/Pound
Settlement exchange rate=(1/1.5235) Pound/US$= 0.656383328 Pound
Gain on Put Option per US dollar=(0.80-0.656383328)Pound= 0.143616672 Pound
Less: Premium paid 0.06 Pound
Net gain on Option per dollar 0.083616672 Pound
Total Gain on hedging=0.083616672*50000000= £          4,180,834 Pound
.(c) Jeff's be;ief is based on Covered Interest Rate Parity
The spot rate after six months will depend on the interest rate in USA and UK
Hence the amount of gain/Loss will be same in option and money market hedge

jeff jeffy answered 2 years ago
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