After their bid was accepted, Dozier has three options to choose from. Of the three choices, the 1st alternative yields the most profit. However, the profit from alternative 1 cannot be guaranteed, and it is much more volatile. The company wants to expand its market to the U.K. and also guarantee the profit (while minimizing exchange risk). Therefore, alternative 2, which has a higher profit margin than alternative 3 is the best hedging choice for Dozier.
Dollar value of the balance
Dollar value of the contract
Percent of Profit
Cost of Hedge
The detailed calculation is shown below.
Alternative 1: Do Nothing
Dozier would choose to remain unhedged, and expose itself to currency risk. We assume the company will exchange the 10% deposit into dollars and deposit into the U.S. banks directly. The company can obtain interest revenue from this part of deposit. The spot pound rate in U.S. dollars on January 14 is 1.437. The company can get £117,500 ×1.437 = $168847.5 when they exchange the deposit. Three-month deposits interest rate in the U.S. is 8% annually. Therefore, the interest rate would be 0.08/4=2%. The company can get $168847.5 × 1.02 = $172224.5 from the 10% deposit.
The company will receive GBP 1.0575 million on April 14,1986. The exchange rate on April 14 remains unknown. However, the pound has weakened over the previous six weeks. CFO, Rothschild was also concerned that the value of the pound might depreciate even further during the next 90 days. We can set three possible rates with different possibilities. According to Exhibit 5, the 3-month forward rate is 1.4198. This is the scenario that has the highest probability of occurring in the future because it is the most reasonable spot rate on April 14. This is the base case from which to measure the other two alternatives. We can also run the regression (see appendix, graph 1) on the recent eight weeks and get the exchange rate on April 14, as the worst case. Another regression can be run based on the half year exchange rate (see appendix, graph 2). This case can be set as the best one which shows long term data.
The total expected revenue from receivables would be:
Base Case Revenue × Probability + Worst Case Revenue × Probability + Best Case Revenue × Probability = 1,505,086.88. Therefore,
Revenue from Receivables
Revenue from Deposit
Total Expected Revenue
Percentage of Profit
We can also perform break-even analysis here. The exchange rate would be 1.3906 when the profit is zero. Therefore, if the pound depreciate to 1.3906, the company would suffer a loss for this contract.
Alternative 2: If Dozier sells pounds forward 90 days
Dozier would incur an obligation to deliver pounds 90 days from 1/14/86 at the rate of 1.437. This would ensure that Dozier would receive a certain amount of money, regardless the change of exchange rate. The 3-Month Forward Rate in U.S. Dollars on 1/14/86 is 1.4198 and the balance is GBP 1.0575 million. Thus, Dozier would receive 1.4198 × £1.0575 million = $1501438.5 after three months. As we discuss above, the company can get 168847.5 × 1.02 = $172224.5 dollars from the 10% deposit. Therefore, the actual revenue of the contract is 1501439 + 172224.5 =$1673663. The total cost is...