(Answered)-1. Foreign Exchange Hedging using Foreign Currency Derivatives: - (2025 Updated Original AI-Free Solution

Question

1. Foreign Exchange Hedging using Foreign Currency Derivatives: Problem

Sarah Forbes is the Chief Financial Officer [CFO] of Daytona Manufacturing, a U.S. based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm for Three million pounds. This single sale is quite large in relation to Daytona?s present business. Daytona has no other current foreign customers, so the currency risk of this sale is of particular concern. The sale is made in March with payment due three months later in June. Sarah Forbes has collected the following financial market information for the analysis of her currency exposure problem:

? Spot Exchange rate: $1.7640 per British pound.

? Three month forward rate: $1.7549 per pound (a 2.2676% p. a. discount on the pound)

? Daytona?s cost of capital: 12%

? U.K. three month borrowing interest rate: 10.0% (or 2.5% per quarter)

? U.K. three month investment interest rate: 8.0% (or 2% per quarter)

? U.S. three month borrowing interest rate: 8.0% ( or 2.0% per quarter)

? U.S. three month investment interest rate: 6.0% (or 1.5% per quarter)

? June put option in the over-the-counter (bank) market for 1,000,000 British pounds;

Strike price $1.75 (nearly at-the money) 1.5% premium

? June put option in the over-the counter (bank) market for 1,000,000 British pounds:

Strike price $1.71 (out-of-the money) 1.0% premium

? Daytona?s foreign exchange advisory service forecasts that the spot rate in there months will be $1.76 per British pound.

Like many manufacturing firms, Daytona operates on relatively narrow margins. Although Ms. Forbes and Daytona would be very happy if the pound appreciated versus the dollars, concerns center on the possibility that the pound will fall. When Ms. Forbes budgeted this specific contract, she determined that the minimum acceptable margin was at a sale price of $5,100,000. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore established at $1.70 per British pound. Any exchange rate below would result in Daytona actually losing money.

Four alternatives are available to Daytona to manage the exposure:

A. Remain un-hedged.

B. Hedge in the forward market.

C. Hedge in the money market.

D. Hedge in the options market. What should Daytona do?