Maria Gonzalez and Trident has concluded another large sale of telecommunication
ID: 2778480 • Letter: M
Question
Maria Gonzalez and Trident has concluded another large sale of telecommunications equipment to Regency (U.K). Total payment of 3,000,000 pounds is due in 90 days. Maria Gonzalez has also learned that trident will only be able to borrow in the United Kingdom at 14% per annum. Given the following exchange rates and interest rates, what transaction exposure hedge is now in Trident's best interest?
1.7550
Assumption Values 90-day A/R in pounds 3,000,000 pounds Spot rate, US$ per pound ($/pounds) $1.7620 90-day forward rate, US$ per pound ($/pounds)1.7550
3-month U.S dollar investment rate 6% 3-month U.S dollar borrowing rate 8% 3-month U.K investment interest rate 8% 3-month U,K borrowing interest rate 14% Put option on the British pound:Stike rates, US$/pound ($/pounds) Strike Rate ($/pounds) $1.75 Put option premium 1.5% Strike rate ($/pounds) $1.71 Put option premium 1% Trident's WACC 12% Maria Gonzalez's expected spot rate in 90-day US$ per pound ($/pound) $1.785Explanation / Answer
Answer:
Alternative #1 Remain Uncovered:
Rate(A) Value(B) Proceeds(A * B)
Value of A/R will be ( 3 million pounds * ending spot rate)
if spot rate is the same as current spot rate $ 1,7620 3,000,000 $ 5,286,000.00
if ending spot rate is the same as current forward rate $ 1,7550 3,000,000 $ 5,265,000.00
if ending spot rate is the expected spot rate $ 1,7850 3,000,000 $ 5,355,000.00
Alternative #2: Forward Contract Hedge
Rate(A) Value(B) Proceeds(A * B)
Sell the pounds forward 3 months, locking in the
Forward rate. Pound A/R@ Forward rate (P* Forward rate) 1.7550 3,000,000 $ 5,265,000.00
Alternative#3 Money Market Hedge
Rate(A) Value(B) Proceeds(A * B)
Borrowing against the A/R, Recceiving Pound Up-front
Exchanging into USD.
Amount of A/R in 90 - Days, in Pounds Pound 3,000,000.00
Discount factor, Pound borrowing rate, for 3 Months
(1/(1+14%*90/360) 0.9662
Proceeds of borrowing up-front in pounds ( 3,000,000 * 0.9662) Pound 2,898,550.72
Exchanged to USD at current spot rate of $1,7620
USD recived against A/R, up-front ( 2,898,550.72 * 1,7620) $ 5,107,246.38
USD need to be carried forward for companies
Carry forward rate , WACC for 90 Days
1+(12%*90/360) 1.0300
Money Market Hedge , USD at the end of 90 days ($ 5,107,246.38 * 1.0300) $ 5,260,463.77
Alternaative # 4: Put option Hedge
Strike Rate ($/Pound) Strike Rate ($/Pound)
1.75 1.71
Option Premium 1.5% 1%
Notional principal of Option (Pounds) 3,000,000 3,000,000
Spot Rate ($/Pound) $1.7620 $1.7620
Option Premium, USD (1.5%*3,000,000*$1.7620) (1%*3,000,000*$1.7620)
$ 79,290 $ 52,860
Carry forward Factor,WACC, for 90 Days 1.0300 1.0300
Total premium cost,in 90 days ( $ 79,290 * 1.0300 ) = $ 81,668.70 ($52,860 * 1.0300) = $ 54.445.80
Proceeds from Put option if excercised ( 1.75 * 3,000,000 ) ( 1.71 * 3,000,000)
$ 5,250,000.00 $ 5,130,000.00
Less cost premium, Including time value - 81,668.70 - 54,445.80
Net proceeds from put options, in 90 days minimum $ 5,168,331.30 $ 5,075,554.20
Ending spot rate needed to be superior to forward: $1.7825 $ 1.7732
Proceeds from exchanging pounds for USD spot ($1.7825 * 3,000,000) ($1.7732 * 3,000,000)
$ 5,347,500.00 $ 5,319,600.00
Less: cost of option (alloed to expire OTM) - 81,668.70 $ - 54,445.80
Net proceeds from put optin,unexcercised ( $ 5,347,500 + (- 81,668.70) ( $5,319,600 + (-54,445.80)
$ 5,265,831.30 $ 5,265,154.20
Analysis:
Maria Gonzalez would receive the most certain USD from the forward contract $ 5,265,000. The money market hedge is less attractive as a result of the higher borrowing costs in the UK now. The two put options would yield unattractive amounts if they had to be exercised.