Since the acceptance of Dozier Industries’ bid, the company CFO has been exploring the methods available to best manage the exchange risk associated with the award payment being dispersed in British Pounds (GBP). He originally considered a forward contract or a spot contract, but is now investigating how currency options could help hedge against uncertain foreign exchange exposure. The CFO needs to decide whether or not options contracts might provide some benefit to hedge the currency risk.
As of 1/14/86, Dozier has received a 10% deposit of the total contract value of £1,175,000.00. At the 1/13/86 exchange rate, this value translates to $170,140.00. The remaining £1,057,500.00 is a receivable that Dozier currently holds and is subject exchange rate risk. In order to hedge against the exchange rate between US dollars (USD) and GBP going down, Dozier could purchase put contracts. These put contracts would appreciate as Dozier’s receivable loses value on the USD after the exchange rate falls below the strike price of the put contracts. If the put contracts are purchased at the right strike price, Dozier would have a guaranteed minimum profit.
Dozier could also sell call options on the USD/GBP exchange rate. These calls would increase the minimum profit that Dozier would receive by the amount of money gained from the sale of the call contracts. However, this would also limit their upside. If the exchange rate were to rise above the strike price of the calls then Dozier’s gains on their receivable would be offset by like losses on the calls. This would set a maximum profit that Dozier could achieve but would also increase the lowest profit they could obtain on this project. Given that this project is a short time frame, 3 months, and that the exchange rate is expected to drop in the future (deduced by 3 month forward rate being lower than the spot rate) we think it would be a smart move by Dozier to sell call contracts in order to increase their minimum profit.
In order to achieve this strategy, Dozier would have to decide how many options contracts to buy as well as at what strike price and expiration to buy them. From the provided information, these options contracts are sold in bundles of £12,500.00 each. For the put options, Dozier would want to buy them as close to the exchange rate at which they will get their 6% profit margin. This was at the original bid date, 12/3/85, when the exchange rate was $1.482/£. The closest strike price that does not exceed this rate is $1.45/£. With the data in Exhibit 2, the latest expiration date for these options would be in March. These put options would cost $0.044. To cover the amount of pounds that Dozier has as a receivable, they would need to buy 84.6 put contracts (£1,057,500.00/12,500). Since you cannot buy a partial contract they would need to buy 85 contracts. In total this would cost Dozier $46,750.00 (=85*12,500*.044).
For the call options, Dozier would need to sell options with a strike price above the exchange rate to receive 6% profit margin, again the the $1.482/£. The only strike price above $1.482/£ listed on 1/14/86 in Exhibit 2 is at $1.50/£. With a March expiration, these calls would cost $0.009 per contract. They would need to sell the same amount of call contracts as they bought in puts (85). Therefore if the exchange rate went above the strike price of $1.50/£ then they would start to lose money on the calls but that would be offset by the gain on the receivable. In total, Dozier would gain $9,562.50 by selling these call options.
This hedging strategy would result in a maximum profit of $76,419.50 or a profit margin of 4.652%. This would occur when the exchange rate reaches $1.50/£. At that exchange rate, Dozier would receive $1,586,250 on their receivable. Added with the deposit that they already obtained and the total from selling the call options, that gives them total revenue of $1,756,390. Deduct from that the cost of buying the...
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