HEDGING TRANSACTION EXPOSURE

A U.S. based MNC has just signed a contract with a British company that calls for the U.S. MNC to provide the British company with consulting services over a three-month period that entails payments in British pound. The current dollar value of the contract is $108,760,000. At the same time the U.S. company signs a three-month contract with another British company to buy supplies for three-month delivery and agrees to settle its bill in British pounds. The dollar value of the British pound contract is $27,190,000. The U.S.-based company is particularly worried about a high degree of uncertainty surrounding the pound exchange rate against the dollar. It decides to consider whether to hedge. The following information is available:

Spot $1.3595/ Bid $1.3796/ Ask

3-month forward $1.3560/ Bid $1.3766/ Ask

6-month forward $1.3520/ Bid $1.3726/ Ask

3-month futures $1.3550/ Bid and $1.3756/

90-day call option #1 $ 1.3683/ strike; $ 0.0160/ premium

90-day put option #1 $ 1.3683/ strike; $ 0.0120/ premium

180-day call option #2 $ 1.3683/ strike; $ 0.0204/ premium

180-day put option #2 $ 1.3683/ strike; $ 0.0320/ premium

90-day dollar interest rate 5.60%per annum (deposit) 7.80% per annum (loan)

90-day pound interest rate 5.10% per annum (deposit) 7.20% per annum (loan)

1. Specify exactly what your exposure is and list the hedging alternatives you should consider.
2. Show how each of these hedging alternatives can be achieved.
3. Assume the following probability distribution for the euro spot rate at the end of three months. Analyze the option versus the no-hedge alternatives and decide which alternative is probably the better one of the two and why.

S₁ Probability

$1.3960/ 35%

$1.3380/ 30%

$1.3210/ 35%