HEDGING USING DERIVATIVES SARASOTA
Question # 00439882
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Updated on: 12/09/2016 06:50 AM Due on: 12/09/2016
QUESTION: HEDGING USING DERIVATIVES SARASOTA
Shiela Forbes is the Chief Financial Officer [CFO] of SARASOTA 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 FOUR million pounds. This single sale is quite
large in relation to SARASOTA’s present business. SARASOTA has no other current foreign
customers, so the currency risk of this sale is of particular concern. The sale is made in JULY
with payment due six months later in JANUARY. Shiela Forbes has collected the following
financial market information for the analysis of her currency exposure problem: Spot Exchange rate: $1.4640 per British pound. Six-month forward rate: $1.4549 per pound SARASOTA’s cost of capital: 14% U.K. annual borrowing interest rate: 16.0% (or 8% interest for six months) U.K. annual investment interest rate: 14.0% (7% interest for six months) U.S. annual borrowing interest rate: 8.0% (4.0% interest for six months) U.S. one-year investment interest rate: 6.0% (3% interest for six months) January put option in the over-the-counter (bank) market for 1,000,000 British pounds;
Strike price $1.45 (nearly at-the money) 2.0% premium SARASOTA’s advisory service forecast the spot rate in Six months will be $1.46 /pound. Like many manufacturing firms, SARASOTA operates on relatively narrow margins. Although
Ms. Forbes and SARASOTA 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
$5,600,000. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore
established at $1.40 per British pound. Any exchange rate below would result in SARASOTA
actually losing money on the transaction.
Four alternatives are available to SARASOTA 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 SARASOTA do?
Shiela Forbes is the Chief Financial Officer [CFO] of SARASOTA 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 FOUR million pounds. This single sale is quite
large in relation to SARASOTA’s present business. SARASOTA has no other current foreign
customers, so the currency risk of this sale is of particular concern. The sale is made in JULY
with payment due six months later in JANUARY. Shiela Forbes has collected the following
financial market information for the analysis of her currency exposure problem: Spot Exchange rate: $1.4640 per British pound. Six-month forward rate: $1.4549 per pound SARASOTA’s cost of capital: 14% U.K. annual borrowing interest rate: 16.0% (or 8% interest for six months) U.K. annual investment interest rate: 14.0% (7% interest for six months) U.S. annual borrowing interest rate: 8.0% (4.0% interest for six months) U.S. one-year investment interest rate: 6.0% (3% interest for six months) January put option in the over-the-counter (bank) market for 1,000,000 British pounds;
Strike price $1.45 (nearly at-the money) 2.0% premium SARASOTA’s advisory service forecast the spot rate in Six months will be $1.46 /pound. Like many manufacturing firms, SARASOTA operates on relatively narrow margins. Although
Ms. Forbes and SARASOTA 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
$5,600,000. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore
established at $1.40 per British pound. Any exchange rate below would result in SARASOTA
actually losing money on the transaction.
Four alternatives are available to SARASOTA 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 SARASOTA do?
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Rating:
/5
Solution: HEDGING USING DERIVATIVES SARASOTA