Dozier’s bid of (British pounds) GBP1.175 million to install an internal security system
the British firm had transferred a 10% deposit (GBP117,500),
Rothschild was planning on receiving GBP1.0575 million on April 14, 1986.
On January 13, the day the bid was accepted, the value of the pound was (U.S. dollars) USD1.4480.
Hedge strategy: The spot hedge worked similarly in that it also created a pound obligation 90 days hence. Dozier would borrow pounds and exchange the proceeds into dollars at the spot rate. On April 13, Dozier would use its pound receipts to repay the loan. Any gains or losses on the receivable due to a change in the value of the pound would be offset by equivalent losses or gains on the loan payment.
John Gunn indicated that there would be no difficulty for Southeastern to arrange the pound loan for Dozier through its correspondent bank in London. He believed that such a loan would be at 1.5% above the U.K. prime rate.
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 = $18,198.00 or $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) =