Small Business Dilemma

Hedging Decisions by the Sports Exports Company

Jim Logan, the owner of the Sports Exports Company, will be receiving about 10,000 British pounds about one month from now as payment for exports produced and sent by his firm. Logan is concerned about his exposure because he believes that there are two possible scenarios: (1) the pound will depreciate by 3 percent over the next month or (2) the pound will appreciate by 2 percent over the next month. There is a 70 percent chance that (1) will occur. There is a 30 percent chance that (2) will occur. Logan notices that the prevailing spot rate of the pound is $1.65, and the one-month forward rate is about $1.645. Logan can purchase a put option over the counter from a securities firm that has an exercise (strike) price of $1.645, a premium of $.025, and an expiration date of one month from now.

1. Determine the amount of dollars received by the Sports Exports Company if the receivables to be received in one month are not hedged under each of the two exchange rate scenarios.

2. Determine the amount of dollars received by the Sports Exports Company if a put option is used to hedge receivables in one month under each of the two exchange rate scenarios.

3. Determine the amount of dollars received by the Sports Exports Company if a forward hedge is used to hedge receivables in one month under each of the two exchange rate scenarios.

4. Summarize the results of dollars received based on an unhedged strategy, a put option strategy, and a forward hedge strategy. Select the strategy that you prefer based on the information provided.