Question

1. Boeing imported a Rolls-Royce jet engine for £6.5 mil payable in one year
   • The US interest rate 4.00% per annum
   • The UK interest rate 6.50% per annum
   • The Spot exchange rate   $ 1.80/£ today

The company decides to use options to hedge the risk of pound exchange one year later. What kind of options should the company buy? Put or Call?

Assume the strike price of the option is $1.82/£ with a premium of $.02/£ paid today. What is the dollar cost one year later if the spot rate then is 1.60 and 2.00 respectively?

How to utilize the money market tools to hedge the risk of pound exchange one year later? In particular, answer which loan (US or UK) to borrow and to lend? How much is the dollar cost one year later (a number you would know today)?

Answer 1

1)	As it is a payable the company would use the 'Call' option
	which, would entitle it to buy the required pounds at the
	stated rate.
2)	Dollar cost under the call option:
	If future spot rate is $1.60/GBP:
	The option would not be exercised. The required pounds
	would be bought at the spot price of 1.60/GBP
	Amount of $ payable at future spot = 6500000*1.60 =	$ 1,04,00,000
	FV of the option premium paid upfront = 6500000*0.02*1.04 =	$        1,35,200
	Total dollar cost under the call option	$ 1,05,35,200
	If future spot rate is $2.00/GBP:
	The option would be exercised. The required pounds
	would be bought at the strike price of 1.82/GBP
	Amount of $ payable at future spot = 6500000*1.82 =	$ 1,18,30,000
	FV of the option premium paid upfront = 6500000*0.02*1.04 =	$        1,35,200
	Total dollar cost under the call option	$ 1,19,65,200
3)	MMH:
	Under the MMH borrowing should be in $ and lending should
	be in GBP.
	Amount to be lent in GBP = 6500000/106.5% =	£     61,03,286
	Amount to be borrowed in $ = 6103286*1.80 =	$ 1,09,85,915
	Dollar cost would be the amount repayable against the borrowing after 1 year = 10985915*104% =	$ 1,14,25,352