Question : DOZIER INDUSTRIES (B)
Richard Rothschild, the chief
DOZIER INDUSTRIES (B)
Richard Rothschild, the chief financial officer of Dozier Industries, was still contemplating how best to manage the exchange risk related to the company's new sales contract. The £1,057,500 balance of the contract was due in three months on April 14, 1986, creating a long position in British pounds. Rothschild had spoken previously to John Gunn, an officer in the International Division of Southeastern National Bank, about hedging his long pound exposure. Gunn had explained two alternatives available to Dozier to reduce the exchange risk: a forward contract or a spot transaction. Either transaction would ensure that Dozier receive a set dollar value for its pound receivable, regardless of any change in the value of the pound. Given his previous analysis of the foreign exchange market, Rothschild was concerned that both of these hedging alternatives would lock in a profit margin below the 6% he had originally anticipated for the contract. He wondered if there were some way to get the upside potential without all the risk.
The pound had weakened since his bid submission date on December 3 (see Exhibit 1), but he was not entirely convinced it would continue to fall, or at least not as much as the forward rate indicated. If the future spot rate were greater than the current forward rate, an unhedged position could lead to a gain, whereas a hedged position would create an opportunity lost. Rothschild wondered if other alternatives were available, and he again called John Gunn at the bank for advice.
Gunn explained that Rothschild could also use currency options to hedge against his uncertain foreign exchange exposure. Options provide a means of hedging against volatility without taking a position on expected future rates. Gunn explained that there are two basic varieties of options contracts: "puts" and "calls." A put gives the holder the right, but not the obligation, to sell foreign currency at a set exercise or "strike" price within a specified time period. A call gives the holder the right to buy foreign currency at a set price. In comparison with a forward or futures contract, the holder of an option does not have to transact at the agreed-upon price, but has the choice or option to do so. Gunn told Rothschild that options are complicated and increase the front end cost of hedging in comparison with a forward hedge. He said Rothschild could find the prevailing option contract prices in the Wall Street Journal (see Exhibit 2).
HISTORICAL SPOT RATE AND FORWARD POUND IN U.S DOLLARS
DATE SPOT 3- MONTH FORWARD RATE
07/08/85 1.3640 1.3490
07/16 1.3880 1.3744
07/23 1.4090 1.3963
07/30 1.4170 1.4067
08/6 1.3405 1.3296
08/13 1.3940 1.3828
08/20 1.3900 1.3784
08/27 1.3940 1.3817
09/4 1.3665 1.3553
09/10 1.3065 1.2960
09/17 1.3330 1.3226
09/24 1.4200 1.4089
10/1 1.4120 1.4005
10/8 1.4155 1.4039
10/15 1.4120 1.4007
10/22 1.4290 1.4171
10/29 1.4390 1.4270
11/5 1.4315 1.4194
11/12 1.4158 1.4037
11/19 1.4320 1.4200
11/26 1.4750 1.4628
12/3 1.4820 1.4704
12/10 1.4338 1.4214
12/17 1.4380 1.4249
12/23 1.4245 1.4114
12/30 1.4390 1.4260
01/7/86 1.4420 1.4284
1/14/86 1.4370 1.4198
FOREIGN CURRENCY OPTIONS ON JANUARY 14,1986
OPTION & STRIKE PRICE CALLS-LAST PUTS-LAST
UNDERLYING CENT PER UNIT JAN. FEB. MAR. JAN. FEB. MAR.
B pound 130 S R 13.50 S R R
144.41 135 S R 9.20 S 0.20 0.50
144.41 140 S 4.50 4.75 S 0.80 1.55
144.41 145 s 1.35 2.50 s 3.10 4.40
144.41 150 s 0.40 0.90 s r r
r- not traded s- no option offered. and Last is premium (purchase price)
Dozier Industries (B)
FOREIGN CURRENCY IPTIONS ON DECEMBER 3,1985
OPTIONS & STRIKE PRICE CALLS-LAST PUTS-LAST
UNDERLYING CENT PER UNIT DEC. JAN. MAR. DEC. JAN. MAR.
B pound 120 29.00 S 28.95 R S R
148.86 130 19.10 R R R R R
148.86 135 13.80 R 14.60 0.05 R R
148.86 140 8.80 R 10.00 0.05 R S
148.86 145 4.00 4.50 5.70 0.20 1.05 3.20
148.86 150 0.65 1.65 3.35 R R 5.60
148.86 155 R 0.50 1.70 R R R
R- NOT TRADED S- NO OPTIONS OFFERED. LAST IS THE PREMIUM(PURCHASE PRICE)
Case B: Additional Information
1. You should treat January 14, 1986 as the date when you are performing your analysis and acting on the analysis (hedging or not hedging).
2. To reduce risk, Dozier will take the 10% initial deposit (pounds) and sell the pounds in the spot market on Jan 14.
3. Any dollars that Dozier receives on Jan 14 are deposited in the bank for 90 days.
4. For the purpose of your calculations, you may ignore the fact that currency option contracts for the pound come in 12,500 pound increments. However, you may discuss this limitation qualitatively in making your recommendation (last discussion question) below.
5. None of the option contracts mature on Apr 14, 1986. Ideally, Dozier would want an option that matures on that date for the purpose of hedging. In deciding which option maturity is best (Feb or Mar), you should consider this problem and choose the maturity that best meets Dozier’s hedging objective. First choose the option maturity that best meets Dozier’s objective. Then in your calculations below, you may treat the options as if they mature Apr 14. Qualitatively, however, you should consider this maturity mismatch in making your recommendation (last discussion question) below.
6. In exhibit 2, 144.41 U.S. cents per pound refers to the spot rate for the pound on Jan 14. This is inconsistent with what is reported elsewhere in both the A and B parts of this case. Continue to use the spot rate given in part A of this case for 1/14/86. For the rest of the table the rows correspond to a strike price between 130 cents and 150 cents per pound. The columns correspond to either call options or put options with either Jan, Feb, or March maturities. Any entry in the table (for example 0.50 cents per pound) is the option premium. In this example, 0.50 cents per pound is the premium for a put option with a March maturity and a strike price of 135 cents per pound.
First read the “B” case, and then address the following questions:
1. Do you recommend using a call or put option to hedge the exchange rate risk? Explain.
2. Do you recommend an option with expiration in Feb. or March?
3. Calculate the U.S. dollar profit or loss for each possible outcome; there will be more than one possible outcome for each option. Recall that with an option, the option does not have to be exercised; the holder may choose to trade in the future spot market. The holder’s choice depends on the future spot rate. Note: You will do these calculations for either all of the call options or all of the put options and for either all of the Feb or all of the March options, depending on your answer to the first two questions above. Hint: Since Dozier’s motive is hedging, you first calculate the revenue in dollars that Dozier will receive for the Pound receivable. Then subtract Dozier’s Costs given in Case A exhibit 3.
4. Which option do you recommend? Explain. Note: You must now select one of the options with a given maturity and strike price.
5. Compare the option hedge to the forward hedge (in the A case) and to remaining unhedged. Which do you recommend? Explain.