Question

In January, ABC Co. in U.S. signed a contract to buy a factory in U.K for £ 2,500,000 payable 3 months later in April. Since the contract is in pound rather than dollar, ABC Co. is considering hedging alternatives to reduce the risk of exchange rate from the purchase. Given the information below:

Spot rate = $1.40/£

3 month forward rate = $1.38/£

ABC's cost of capital is 11% p.a

UK 3-month borrowing rate is 2.5%

UK 3-month lending rate is 1.8%

U.S. 3-month borrowing rate is 2%

U.S. 3-month lending rate is 1.5%

April call options for £ 625,000; strike price $1.42, premium price is 1.5%

ABC Co. forecast for 3-month spot rate is $1.43/£.

The highest acceptable purchase price for this project, is $3,625,000 or $1.45/£

Show the calculation for hedging in money market, forward market, and option market.

Which hedging method will you adopt? Explain and summarize the outcomes.  

Answer 1

HEDGING IN MONEY MARKET:

UK 3-month lending rate is 1.8%

Present Value of £ 2,500,000=2500000/1.018= £ 2,455,796

Amount of US dollar at current spot exchange rate=$1.4*2455796=$3,438114

Borrow $3438114 at US borrowing rate 2%

Convert into £ 2,455,796 at current spot rate $1.4/£

Deposit the amount in UK at 3 month lending rate of 1.8%

After 3 months the deposit will grow to £ 2,500,000 and will be paid

The amount to be paid to US bank with interest=3438114*1.02=$3,506,876

FORWARD MARKET:

Forward rate:$1.38/£

Enter into a forward contract to buy £ 2,500,000

Amount to be paid after 3 months =1.38*2500000=$3,450,000

OPTION MARKET:

Number of Call options Contracts required=2500000/625000=4

Buy 4 Contracts (£2500000 ) Call Options at strike price=$1.42

Premium to be paid=1.5%*1.42*2500000=$53,250

At exchange rate $1.42/£, Cost =1.42*2500000=$3,550,000

If the exchange rate goes up, the gain in call option will offset the increase in cost

Maximum Cost for this alternative:

3550000+53250=$3,603,250

Hedging Method	Maximum Cost
Money Market	$3,506,876
Forward Market	$3,450,000
Option Market	$3,603,250

Forward Market hedging method should be adopted