Question

General Electric sold a machine system to a customer in the UK and billed £30 million payable in one year. GE is concerned with the pound proceeds from international sales and would like to control exchange rate risk. The current spot exchange rate is $1.29/£ and one-year forward exchange rate is $1.27/£ at the moment. GE can buy a one-year put option on £30 million with a strike price of $1.32/£ for a premium of $0.02 per pound. It can also buy a one-year call option on £30 million with a strike price of $1.29/£ for a premium of $0.15 per pound. Currently, oneyear interest rate is 5.1% in the U.K. and 4.0% in the U.S.

a. Compute the guaranteed dollar proceeds from the sale if GE decides to hedge using a forward contract.

b. If GE decides to hedge using money market instruments, what action does GE need to take? What would be the guaranteed dollar proceeds from the sale in this case?

c. If GE decides to hedge using options on pounds, what option (put or call) will GE use? And what would be the ‘expected’ dollar proceeds from the aircraft sale? Assume that GE regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

d. Based on the available information and your calculations above, what is your recommendation to GE for a best strategy (forward hedge vs money market hedge vs options hedge)? Why?

e. Other things being equal, at what forward rate would GE be indifferent between the forward and money market hedge?

Answer 1

Exposure Receivable Quatum & Currency £30 million Home Currency $ Foreign Currency :£ a) Forward contract Hedge Forward Rate : $1.27/E Proceeds £30 million X S1.27/ $38.10 million b) Money Market Hedge Since £30 million is receivable it is Outstanding Asset to the GE, hence we need to create £ Liability Steps 1. Borrow Present value of £30 million for One year in (Foreign Currecy) @ 5.4 % p.a [£30 million /(1+0.054)] £28.46 million 2. Convert £28.46 million in spot £28.46 million X $1.29/E $ 36.71 Million 3. Deposit $36.71 Million for 1 year in @4.10% p.a $36.71 X (1+0.041 $38.22 Million C) Option Hedging Option available in Foreign Currecy 1 year GE need the sell Foreign currency (Pound) Hence Option should be Foreign Currecy PUT Options (Right to Sell) at the end of 1 years a) Proceeds= £30 million X $1.27/ $38.10 million b) Gain / Loss from Put Option Strike Price (X) = $1.32/£ Price (S) $1.27/ Since X S Put option can be exercised £30 million X (1.32-1.27)/E 1.5 Million c) Premium Cost £30 million X $0.02 /E $0.6 Million d) Premium Funding Cost 0.6 Million X 4% * 1 Year -$ 0.024 Million $38.98 Million Net Proceeds from Option Hedging (A+B-C-D) D) Best strategy for GE Based on the available information and as per above calculations Option Hedging is recommendation to GE for a best strategy because by using option hedding GE can get maximus $ Proceeds compared to other two alternatives E) Forward rate indifferent between the forward and money market Hedge Money Market Hedge Proceeds = $ 38.22 Million Per Pound $ 38.22 Million /E30 million $1.274/E Hence when Forward rate is $1.274/E would indifferent between the forward and money market hedge