Question

1. Boeing just signed a contract to sell a Boeing 787 aircraft to British Airways. British Airways will be billed £26 million which is payable in one year. The current spot exchange rate is $1.40/£ and the one-year forward rate is $1.43/£. The annual interest rate is 6.0% in the U.S. and 5.0% in UK. The premium for a one-year put or call option with the exercise rate of $1.43/£ is 1%. Boeing is concerned with the volatile exchange rate between the dollar and the pound and would like to hedge exchange exposure. Four alternatives are available to Boeing to manage the exposure: 1) remain unhedged; 2) hedge in the forward market; 3) hedge in the money market; or 4) hedge in the options market. (Show all work)

(a) What action does Boeing need to take for each hedging alternative?

(b) Calculate the future dollar proceeds of the sale to British Airway under the four alternatives if the spot exchange rate becomes $1.45/£ in one year.

(c) Calculate the future dollar proceeds of the sale to British Airway under the four alternatives if the spot exchange rate becomes $1.40/£ in one year.

(d) At what future spot exchange do you think Boeing will be indifferent between the option and money market hedge?

(e) At what future spot exchange do you think Boeing will be indifferent between the option forward hedge?

(f) At what future spot exchange do you think Boeing will be indifferent between the forward and money market hedge?

(g) Illustrate the future dollar proceeds of the sale to British Airway under the four alternatives.

Need hlep with question A to G

Answer 1

BOING IS AN EXPORTER

BRITISH AIRWAYS IS AN IMPORTER

AN EXPORTER HAS TO SELL RECEIVABLES TO SAFEGUARD ITSELF.

(a)

FOUR ALTERNATIVES

(1) If hedging is not done :

spot rate : $1.40 = 1 £

forward rate : $ 1.43 = 1 £

If hedging is not done, & pound appreciates, then there will be a profit to boeing

If hedging is not done, & pound depreciates, then there will be a loss to boeing

(2) hedge in forward market

spot rate : $1.40 = 1 £

forward rate : $ 1.43 = 1 £

so if boeing today enters into forward contract, it will have 1 £ =$ 1.43,

so boeing will have profit of ($1.43- $1.40) x £26 million = £ 0.78 million

so total sale proceeds = 26000000 x 1.43 = 37180000

(3) hedge in money market

step 1 : borrow pound today

amount of pound to be borrowed = 260,00,000/ 1.05 =24761904.76 pound

step 2 : convert this 24761904.76 pound to dollars today at spot rate

spot rate : $1.40 = 1 £

dollar received today = £ 24761904.76 x $1.40 = $ 34666666.66

step 3 : invest in US @6%

After a year, amount receivable = $ 34666666.66 (1.06) = $ 36746666.66

step 4 : you have to pay pound £24761904.76 (1.05) = 26000000 after a year, which is exactly the same you will receive from your party

so $ 36746666.66 received without any risk

(4) hedge in options market

here we will go for put option as we are exporter

the option premium payable is $1.43/£ is 1%

so premium payable is = £ 260,00,000 x 1.43 x 1% = $371800

now if price is below $1.43/£, we will exercise the option otherwise not.

so in any case the minimum amount to be received = (26000000 x $1.43) - $371800 = $36808200

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(b) if exchange rate is $1.45 = 1£

then

(1) If hedging is not done :

boeing will have benefit as rate has moved from $1.40 to $1.43 to $1.45/£

so total sale proceeds = 26000000 x 1.45 = 37700000

(2) hedge in forward market

boeing will not benefit as forward contract is already entered into

so total sale proceeds = 26000000 x 1.43 = 37180000

(3) hedge in money market

as we have aleady hedged, no change in total sale proceeds

so $ 36746666.66 received without any risk

(4) hedge in options market

now as the rate has moved to $1.45, boeing will not exercise the option

and convert £26000000 at current rate $1.45

so total sale proceeds = 26000000 x 1.45 = 37700000

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(c) if rate changes to $1.40/£

(1) If hedging is not done :

boeing will have loss as rate has moved from $1.43 to $1.40/£

so total sale proceeds = 26000000 x 1.40 = 36400000

(2) hedge in forward market

boeing will not benefit as forward contract is already entered into

so total sale proceeds = 26000000 x 1.43 = 37180000

(3) hedge in money market

as we have aleady hedged, no change in total sale proceeds

so $ 36746666.66 received without any risk

(4) hedge in options market

now as the rate has moved to $1.40, boeing will exercise the option

total sale proceeds = (26000000 x $1.43) - $371800 = $36808200

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(d) rate which makes option & money market hedge indifferent

money to be received under money market hedge = $ 36746666.66

amount in pound receivables = £ 26000000

therefore equilibrium rate = $36746666.66/ £26000000 = $ 1.4133/£

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(e) rate which makes option & forward market hedge indifferent

money to be received under forward market hedge = $ 37180000

amount in pound receivables = £ 26000000

therefore equilibrium rate = $37180000/ £26000000 = $ 1.43/£

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(f)rate which makes money market & forward market hedge indifferent

money to be received under money market hedge = $ 36746666.66

amount in pound receivables = £ 26000000

therefore equilibrium rate = $36746666.66/ £26000000 = $ 1.4133/£