Hedging using Foreign Currency Derivatives
Shiela Penny is the Chief Financial Officer [CFO] of SALEM Manufacturing, a U.S. based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm for One million pounds. This single sale is quite large in relation to SALEM's present business. SALEM has no other current foreign customers, so the currency risk of this sale is of particular concern. The sale is made in September with payment due three months later in December. Shiela Penny has collected the following financial market information for the analysis of her currency exposure problem:
- Spot Exchange rate: $1.5640 per British pound.
- Three month forward rate: $1.5549 per pound
- SALEM's cost of capital: 16%
- U.K. Annual borrowing interest rate: 12.0% (or 3.0% per quarter)
- U.K. Annual investment interest rate: 10.0% (or 2.5% per quarter)
- U.S. Annual borrowing interest rate: 12.0% ( or 3.0% per quarter)
- U.S. Annual investment interest rate: 8.0% (or 2.0% per quarter)
- December put option in the over-the-counter (bank) market for 1,000,000 British pounds; Strike price $1.55 (nearly at-the money) 1.5% premium
- December put option in the over-the counter (bank) market for 1,000,000 British pounds: Strike price $1.51 (out-of-the money) 1.0% premium
- SALEM's foreign exchange advisory service forecasts that the spot rate in there months will be $1.56 per British pound.
Like many manufacturing firms, SALEM operates on relatively narrow margins. Although Ms. Penny and SALEM would be very happy if the pound appreciated versus the dollars, concerns center on thepossibility that the pound will fall. When Ms. Penny budgeted this specific contract, she determined that the minimum acceptable margin was at a sale price of $1,500,000. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore established at $1.5 per British pound. Any exchange rate below would result in SALEM actually losing money on the transaction.
Four alternatives are available to SALEM to manage the exposure:
1. Remain un-hedged.
2. Hedge in the forward market.
3. Hedge in the money market.
4. Hedge in the options market. What should SALEM do?
Four alternatives are available to Salem to manage the exposure:
1. Remain un-hedged.
2. Hedge in the forward market.
3. Hedge in the money market.
4. Hedge in the options market.
What should Salem do?