On January 13, 1986 Dozier Industries, an American based firm, received notice that a bid on a project in the United Kingdom had been accepted. The project was to bring in £1,175,000 in revenue. Therefore, the revenue received for this project will need to be transferred into US dollars. When Dozier issued the bid on December 3, 1985 the project the exchange rate was $1.4820/£. This rate would have provided Dozier with the desired 6% profit on the project. On January 13, the day the bid was accepted, the exchange rate had changed to $1.4480/£. On January 14 the rate had change again to $1.4370/£. This inflation in the dollar to the British pound has severe implications for the profit potential on this project. Dozier currently has four different alternatives they can choose to do; they can do nothing, use a forward contract, use a money market hedge, or buy options.
If Dozier Industries elects to do nothing they have no control over whether the project earns a profit or suffers from a loss. Using this strategy Dozier is hoping that the British pound will regain value against the dollar. Their hope is that the British pound will remain close to the spot rate it was bid at so when they receive payment of the original bid they can maintain or maximize profit potential. By following this strategy Dozier is taking the risk that the project works at a loss. Performing a break-even analysis reveals the dollar can appreciate to the British pound to an exchange rate of $1.3893/£ before the project is no longer profitable.
If Dozier wishes to ensure that they will make a profit, removing risk of loss, then they can enter into a 90 day forward contract to sell British pounds at the forward rate of $1.4198/£. This method will provide a total profit of 1.96%. The profit is calculated by adding the total receivable at the forward rate and the future value of the 10% deposit on the contract received on January 13 and then reinvested in the US (converted at the spot rate of that day). This profit percentage is quite small relative to the 6% desired profit. Therefore, it is only an attractive choice if Dozier fears that doing nothing will result in a loss.
Money Market Hedge
An alternate method exists to ensure a profit on the project. Dozier Industries could use a money market hedge strategy. Dozier would borrow the present value of the $1,057,500 remaining balance to be paid by the British company now at 15% annually, or 1.5% above the prime lending rate in the UK. Dozier would then convert the money to US dollars at the January 14 spot rate of $1.4370/£. Next, Dozier would invest the money in the US at an annual rate of 8%. Dozier would pay back the loan they took out in the UK when the British firm pays Dozier three months from now. The profit on the project would be calculated as a combination of the future value of the 10% deposit paid on January 13 invested in the US (converted to dollars at the spot rate of that day) and the value of the borrowed amount changed to dollars and also invested in the US. This method provides a profit of 1.51%. Compared to only entering into a forward contract, this method is inferior. Dozier would not use this method if their goal was to prevent a loss because the forward hedge method provides a better profit by nearly .5%.
Dozier’s management did not consider buying options while preparing the bid or at any point before receiving the deposit on the contract. The British pound had fluctuated quite a bit over the past six months and in January had depreciated approximately 1.4% against the dollar. In order to hedge as much risk as possible on the British pounds being received, Dozier’s CFO should consider buying 84 options contracts, totaling £1,050,000. This would leave only £7,500 fully exposed to the exchange rate volatility. The options available to hedge against the long British...