dozier hedging

Topics: Forward contract, United States dollar, Forward price Pages: 4 (1009 words) Published: September 21, 2013
Dozier Hedging Alternatives

Forward Market Hedge:
Dozier would purchase U.S. dollars under a forward contract. The contract would obligate Dozier to pay £1,057,500 in exchange for
£1,057,500 x 1.4198 $/£ = $1,501,438.50
assuming the transaction was at the quoted 3-month forward rate in Exhibit 4. Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50
Dozier would accepting a reduction in the revenue from the contract of
$1,519,627.50 - $1,501,438.50 = $18,198.00or
$18,198 / $1,519,627.50 = 1.20%
Money Market Hedge:
In this case, Dozier would borrow an amount of British pounds that would obligate Dozier to a principal and interest payment in three months that would exactly equal the amount that Dozier expects to receive. At an interest rate of 15% per year (3.75% for three months, the amount to borrow equals £1,057,500 / (1.0375) = £1,019,277.11

Dozier would immediately exchange the pounds into dollars at the current exchange rate. So Dozier would have
£1,019,277.11 x 1.4370 $/£ = $1,464,701.21
The problem with this alternative is that we have dollars today (if you want to consider that a problem) and we need to compare the results with the forward hedge which gives us dollar three months from now. So, we need a way to compare dollars today with dollars in three months; i.e., we need an interest rate. So we ask, what can Dozier do with dollars today? Well they could invest the money in a safe investment, providing an 8.0% annual interest rate. If we assume that the company's opportunity cost of funds is investment at 8.0% (2% for three months), we can calculate how much money they would have in three months time.

$1,464,701.21 x (1.02) = $1,493,995.23
Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50
Dozier would accepting a reduction in the revenue from the contract of
$1,519,627.50 - $1,493,995.23 =...
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