BAE Systems, the UK defence manufacturer has just purchased a Korean company that produces parts used in their machines. The purchase price was Won 7,800 million. Won 1,500 million has already been paid and the remaining Won 6,300 million is due in six months. BAE is now considering alternative strategies to managing its foreign exchange risk:

a) Doing Nothing: Hoping that the GBP will remain the same or strengthen against the Korean Won

b) Using Futures: The current spot rate is Won 1,071.95/GBP and the six-month forward rate is Won 1.103.28/GBP. The six-month Korean Won interest rate is 12% while the six-month Pound Sterling rate is 5% per annum.

c) Using Call Options: A 6-month Call option on Won with a strike price of 1,100/GBP has a price of 2.83% of the strike price, i.e. 31.13.

d) Using Put Options:. A six-month Put option at the same strike has a price of 2.48%., i.e. 27.28

You are asked to identify and quantify BAE Systems foreign exchange risk exposure. Under alternative scenarios for the movement of the GP against the Korean Won, how might alternative strategies or even combinations of strategies, perform?

Taking into account the firms risk tolerance as well as other factors, as their advisor, what approach do you recommend to managing their foreign exchange exposure and why?

How do choices faced by BAE involve both translation as well as transaction risk?

As background, BAE can invest at these rates or borrow at 1% per annum above those rates (i.e. 100 basis points greater, e.g. 6% if the market is 5%). BAE has a weighted average cost of capital is 9%, per annum.