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 $1,505,086.88 $ 1,501,438.5 $1,493,995.00
Dollar value of the contract $1,677,311.33 $1,673,663.00 $1,666,219.73
$34,528.32 $30880 $ 23,437.00
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,