Question

Thomsen Company just concludes negotiations for the sale of telecommunication equipment to Churchill, a British firm, for ?1,000,000

The sale is made in March with payment due three months later in June

The financial and market information is as follows:

- Spot exchange rate: $1.7640/?

- Three-month forward rate: $1.7540/?

- Cost of capital for Thomsen company: 12%              

- U.K. three-month deposit (borrowing) interest rate: 8% (10%)

- U.S. three-month deposit (borrowing) interest rate: 6% (8%)

- Put option expired in June for ?1,000,000 with the strike price $1.75/? ($1.71/?) is quoted as 1.5% (1.0%) premium or (2) a put option with the strike price of $1.71/? and the premium of 1%

- Thomsen’s foreign exchange advisory service forecasts that the spot rate after three months will be $1.76/?

- Thomsen’s minimum acceptable margin is at a sales price of $1,700,000, which implies the budget rate, the lowest acceptable dollar per pound exchange rate, is at $1.70/?

Thomsen has four alternatives to manage transaction exposure:

- Remain unhedged

- Hedge in the forward market

- Hedge in the money market

- Hedge in the options market

Analyze the choices for Trident.

Answer 1

Calculation of cash flows to Thomson in June under the 4 available options:

1) Remain unhedged:

In June: Receive payment of £1,000,000. Convert it into $ using then spot rate of $1.76/£

Amount received in $ = (1000000*1.76) =$1,760,000

2) Hedge using forward market.

In March: Enter the 3-month forward contract to sell £1000,000 @ $1.7540/£

In June: Receive payment of £1,000,000. Convert it into $ using forward contract

Amount received in $ = (1000000*1.7540) =$1,754,000

3) Hedging using Money market:

In March:

? borrow present value of £1,000,000 receivable in 3-months = £1,000,000/(1+(0.10*3/12)) = £975,609.76

? Convert £975,609.76 into $ using spot rate = $(975,609.76*1.7640) =$1,720,975.61

? Invest the $1,720,975.61 amount for 3-months @ 6% p.a.

In June:

? Receive payment of £1,000,000. and repay the £ loan = £975,609.76*(1+(0.10*3/12))= £1,000,000

? Receive from $ investment = $1,720,975.61*(1+(0.06*3/12)) = $1,746,790.24

4) Heding through options:

Since we have to sell £ in 3-months, buy 3-month put option for £1000,000 with strike price of $1.71/£.

In March:

? Borrow for 3-months @ 8% p.a. the $ amount required to pay for option premium.

£ option premium amount =1000,000*0.01 =£10,000.00

$ equivalent to be borrowed = 10,000*1.7640 = $17,640.00

In June:

? The spot price($1.76/£) >excercise price($1.71/£), therefore the option expires worthless

? Receive payment of £1,000,000. Convert it into $ using then spot rate of $1.76/£

Amount received in $ = (1000000*1.76) =$1,760,000

? Repay dollar loan = $(17640*(1+(0.08*3/12))) = $17,992.80

Net $ proceeds = 1,760,000-17992.80 = $1,742,007.20

The best alternative is to remain unhedged as the $ value received is highest.