Question

Boeing just signed a contract to sell a Boeing 737 aircraft to British Airways and will receive £50 million in six months. The current spot exchange rate is $1.3030/£ and the six-month forward rate is $1.3100/£. Boeing can buy a six-month put option on the British pound with an exercise price of $1.3500/£ for a premium of $0.0542/£. Currently, the six-month interest rate is 1.450 percent per annum in the United States and 0.410 percent per annum in France. Boeing believes that the British pound would likely appreciate from its current level, but would still like to hedge its exchange exposure.

1. Explain how Boeing should do a forward hedge. Compute the guaranteed dollar proceeds from the British Airway sales if Boeing decides to hedge using a forward contract.

2. If Boeing decides to hedge using put options on the British pound, what would be the “expected” net dollar proceeds from the British Airway sale? Assume that Boeing regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

3. At what future spot exchange rate do you think Boeing will be indifferent between the option hedge and forward hedge?

** Illustrate your answers with the proper post-hedging net $ proceed charts, labeling your foreign exchange rates and net proceeds properly.

Answer 1

Answer:-

1

Answer 1.

Given that, the Spot exchange rate is $ 1.3030/£ and six month Forward Rate is $1.3100/£. Today Boeing has no cash to receive and after 6 months will receive £50 million which has to be converted to $ (i.e has to buy $ after six months). Therefore when the Sell Contact is signed Boeing to Hedge the exchange fluctuation has to Short six month forward contracts today.

The dollar proceeds due to hedging using Forwards = $(1.3100 – 1.3030)*50,000,000 = $ 350,000

Answer 2.

As it is given that current Forward Rate is Unbiased predictor of the Future Spot Exchange Rate which means that Future Spot Rate = E(Current Forward Rate) where E(.) is the expected value of.

Hedging using Put Options:

As Boeing will receive £ 50 Million in six months the equivalent value of $ 82.8 million has to be the amount that has to be received after 6 months. But due to exchange rate fluctuation the amount that has to be received will reduce if the exchange rate falls.

Therefore we can use put options to avoid any loss due to fall in exchange rate. As the put options available with strike of 1.35 $/£ is available for a premium of $ 0.0542/£.

As Boeing believes that current forward exchange rate as an unbiased predictor of the future spot exchange rate, to hedge the £ 50 Million it has to buy the put options at $ 0.0542/£ at total value of $ 350,000.

After 6 months the Spot value will be $ 1.3100/£. Therefore the net dollar proceed will be

= 3,50,000 – (1.3100-1.3030)*3,50,000 = 0

Answer 3.

For the choice to be indifferent between Forwards and Options hedge:

The dollar proceeds from Forwards Hedge = 3,50,000 which has to be equal to dollar proceeds from hedging using Options.

Let x be the Future Spot Rate; - 3,50,000 – (x - 1.3030)*3,50,000 = 3,50,000

Solving for x we get x = 1.2800