Question

The San Antonio Aviation Company of San Antonio, Texas, has received an order for 195,000 seats for the Airbus A-320 from the Airbus Consortium in Great Britain, payment to be in British pounds sterling. The seats will be shipped to Airbus under the terms of a letter of credit issued by the Royal Bank of Scotland on behalf of Airbus for the benefit of SA Aviation. This Letter of Credit specifies that the face value of the shipment, £20,500,000, will be paid 180 days after the Royal Bank of Scotland accepts a draft drawn in accordance with the terms of the Letter of Credit. No exchange rate is quoted in the Letter of Credit.

The current discount rate in London on 180-day banker’s acceptances is 8% per annum, and SA Aviation estimates its weighted average cost of capital to be 9% per annum. The commission for selling a banker’s acceptance in the discount market is 1.25% of the face amount.

       (a) Would the San Antonio Aviation Company gain by holding the banker’s acceptance to

             maturity or discounting the banker’s acceptance at once?

       (b) Does San Antonio Aviation Company incur any risks in this transaction?

            How might they manage these risks given the information below?

      

The national discount rate in the US is 3% while the rate in the UK is 5%. The current Spot Rate is: 0.6410£/$. The 180-day Forward Rate is £0.6415/$. UK lending rates are 8%. The 180 day strike price for the American Put Option to sell Sterling is: $1.5574/£ with a 0.2 cent premium per £.

4. List the correct sequence involved AND all required documents in the export of seats from the SA Aviation Company to the Airbus Consortium in the UK.

I need part d. answered please.

Answer 1

a.

Present value of GBP receivable = 20,500,000/(1+.09*180/360) = 20,500,000/1.045 = 19,617,224.88

	Particulars	Amount
	Face Value of LC	20,500,000
Less:	Discount (4% for 180 days)	820,000
Less:	Commission (1.25%)	256,250
	Net amount received	19,423,750

	If LC is held till maturity	19,617,224.88
	If LC is discounted	19,423,750
	Net gain in holding till maturity	193,474.88

Since the receivable is higher in holding till maturity, the accepatnce should be held till maturity.

b. Yes

c. There are 3 options available to mitigate foreign risk:

Buy a forward, Money Market Hedge, Buy a put option - The option to sell currency at a future date

Buy a forward:

If the forward contract is bought the receivable in the future is 20,500,000*Exchange Rate under Forward

The rate given is: GBP 0.6415/$, thus the rate for GBP will be 1/0.6415 = $1.5588/GBP

Recivable = 20,500,000*1.5588 = 31,956,352

Money Market Hedge:

Under a money market hedge, the company will borrow funds in UK such that the payable against the loan 180 days hence is equal to the receivable 180 days hence. The amount so borrowed will be converted in $ and invested at the discount rate in US.

Borrow GBP =20,500,000/1.04 = 19,711,538.46

Buy $ at spot rate = 19,711,538.46/0.6410 = 30,751,230.05 $

Invest $ at 1.5% for 180 days

After 180 days, the loan payable (GBP) = 19,711,538.46 *1.04 = 20,500,000

Maturity of $ investment receivable = 30,751,230.05*1.015 = 31,212,498.50

Receivable under Money Market Hedge = 31,212,498.50

Buy a put

A put is an option to sell GBP in the future. In case the spot rate for $/GBP is higher, the company will choose not to exercise the put and sell in the spot market.

If the put is exercised receivable is = (20,500,000- 20,500,000*0.2/100)*1.5574 = 31,862,846.60

Receivable under put = 31,862,846.60

Since the receivable is highest under forward, the company should hedge their risk using a forward contract.

a. List of sequence and documents:

The Airbus Consortium applies for a Letter of Credit in Royal Bank of Scotland. Royal Bank of Scotland issues L/C in favor of Airbus Consortium and will send the L/C to San Antonio's bank in Texas. The bank will confirm the L/C and will advise the company of the opening of L/C. San Antonio will ship the seats to Airbus Consortium, shipping on an order of bill of lading made deliverable to itself, so that the legal title of the seats at this stage of the transaction. San Antonio will draw a 180 draft on Royal Bank of Scotland in compliance with the terms mentioned in L/C and will present the draft alongwith required documents to its own bank in Texas. The Texas bank will endorse the draft and forward the same to Royal Bank of Scotland alongwith bill of lading and other documents. RBS will then accept the draft which can either be discounted or held till maturity by the US company. RBS retains the bill of lading at this time so that the legal title for the seats is with them. RBS will collect funds from Airbus Consortium and then pass on the bill of lading to them . At the time of maturity, the US company will present the acceptance to the Texas bank and the Texas bank will forward the same to RBS for collection of funds. Once the funds are collected they will be sent to the exported.

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