5. Derivatives are an essential tool for hedging of currency, interest rate, and commodity price exposures. What is the definition of a financial derivative? Which derivatives are commonly used for hedging of forex exposure? What are some guidelines for the proper use of derivatives by managers in non-financial firms?

1. Illinois Machinery Co. has sold a numerically controlled milling machine to a firm in Britain and will receive payment of 3 m in 90 days. The spot rate is $1.2780/ and the 90 day forward rate is $1.2675/. The FX advisor at the firms bank in Chicago forecasts that the rate will be $1.3000/ in 90 days. Interest rates (invest/borrow) are 2.0%/4.8% pa in the U.K. and 1.0%/4.0% pa in the U.S. The bank also offers a 90 put option on the pound with a strike of $1.2800/ and a premium of 3%. Calculate the different hedging alternatives for the firm and make a recommendation.