Forward Contract Hedge
The first option available to Dozier Management to hedge the risk of the Great British Pound (GBP) depreciating against the United States Dollar (USD) is to enter into a contract to sell forward £1,057,500 for USD in 90 days. Therefore, on April 14th, when Dozier receives the remaining GBP from the security system contract, it would be required to deliver these GBP to the counterparty of the forward contract. This option would make the firm immune to any fluctuations in the value of GBP relative to USD over the next 90 days as the firm would lock in the USD/GBP exchange rate for their receivable of £1,057,500. At the current 3-month forward rates of (1.4198 USD/GBP), Dozier would capture guaranteed proceeds of $1,501,438.50.
Dozier also received £117,500 as deposit for the contract. The firm could sell this deposit on the spot foreign exchange market at the current rate of 1.437 USD/GBP and receive $168,847.50. Investing the proceeds of the deposit in a U.S. money market account would yield $171,988.00 in 90 days. It is important to note that since the contract was settled on December 3rd, the GBP depreciated by over 3% (from (1.4820 to 1.437 USD/GBP). As a result of this movement, the USD value of the deposit was reduced by the same 3% from $174,135.00 to $168,847.50. Under the strategy of using the forward contract hedge, the firm would be assured of receiving a total of $1,673,426.50 ($1,501,438.50 plus $171,988.00). Given the total cost of the project of $1,642,783, the firm would realize a profit of $30,643.50, a margin of 1.87%. This profit margin would be significantly below the projected 6% return.
Spot Market Hedge
An alternative to the forward contract hedge is Dozier could create a matching liability for the GBP receivable by borrowing GBP from the bank, immediately exchanging the GBP for USD in the spot foreign exchange market and then investing the USD proceeds in a three month deposit. At the time the receivable comes due, Dozier would use the GBP proceeds to repay the liability and keep the USD amount of the three month profit. These series of transactions would eliminate the risk of the depreciation of the Pound.
GBP funding is available at a rate of 15% (13.50% GBP prime rate plus 150 basis point credit spread). To create a GBP liability of £1,057,500 GBP in 90 days, the firm would need to borrow its present value of £1,021,188.50. The firm would then receive $1,467,447.88 at the current exchange rate. As the USD investment would be over $1.0 million it would be classified as a large deposit and qualify for the premium interest rate. As in the previous scenario, Dozier would immediately exchange the £117,500 deposit into $168,847.50. The total proceeds of $1,636,295.38 could then be invested in a deposit bearing 8%, earning interest of $31,787.57 over 90 days. The firm would receive a total of $1,668,082.94 from the initial deposit, the principle and interest in the three month investment. Given the project costs stated above, the firm would realize a profit of $25,299.94, representing a margin of 1.54%.
Spot Market Hedge
The final option available to Dozier Management is to leave the 1,057,500 GBP receivable un-hedged. If the GBP were to appreciate against the USD over the next 90 days, Dozier would reap the full benefit of this appreciation. Conversely, should the GBP depreciate versus the USD over the next 90 days, Dozier would suffer a loss...