Help with #3 - Value those options using the Black-Scholes -show work and explain and/or excel if possible. Hint-problem is based on 3 cash flows.

Maxwell Engineering Case

The result of a bid submitted to the Mexican government's agency in charge of the rural electrification project had been most disappointing. On November 30, 1984, John Vink, manager of Power Systems at Maxwell, was notified by the Mexican government that Maxwell had been underbid by the Swiss German Consortium of Brown-Boveri & Siemens (BB-S). Maxwell had entered the bidding for the construction of 5 high-voltage units near Guadalajara, Mexico's thirteenth largest industrial center.

The bid submitted by Maxwell in March 1984 totaled $ 63 million to be paid in three equal yearly installments due on the first of December 1985, 1986 and 1987, with installation to be completed in the last six months of 1985.

Attached to the reply from the Mexican government was a photocopy of the Brown-Boveri & Siemens bid which was virtually identical from the standpoint of technical specification, but which differed in the terms of payment.

The bid by BB-S offered the equivalent of $ 56 million, denominated in Deutsche Marks at a rate of DM 3.14/$. The payment schedule was identical to Maxwell's, but the bid required payment in three equal installments of Deutsche Marks.

A second round of bidding was to be held on December 10, and if Maxwell wanted to stay in the race, the bid had to be sent in today, December 1, 1984 in order to meet this deadline. John Vink was concerned that the strong dollar had just about closed his export market. John knew that in spite of his position with the firm, his background as a civil engineer did not equip him with the creative financial skills that could close the seemingly unbridgeable gap between the two bids. Fortunately, John felt that he could depend on his newly hired assistant holding an MBA degree to help him with this problem.

1. Suppose you had to advise the Mexican government on which bid to accept. Analyze the financial implications of the competing bids and develop the criteria you would use to select the winning bid. You can assume that the Mexican government uses the U.S. $ as a currency of reference given its oil based foreign exchange receipts. As a rough guide to your calculations you can use the rates quoted below.

2. Assume now that you have to advise John Vink of Maxwell. You have to suggest ways of improving Maxwell's chances of obtaining the bid. Discuss the advantages and disadvantages of the following two "solutions":

(a) Submit a bid identical to the Swiss-German consortium (but perhaps for a slightly lower amount).

(b) Add a clause to the bid that allows the Mexican Government to pay either $21 million or DM 58.61 million on the stipulated dates. In particular, analyze the effects of this clause if (i) they must decide today which currency they will use for each payment or (ii) if they may flexibly wait until each payment to decide on the currency.

3. Using recent data on the Euro, calculate the annualized volatility of the exchange rate. (Note: The annualized volatility is times the daily volatility). Express the flexible payment alternative 2. (b) (ii) above in terms of currency options. Value those options using the Black-Scholes formula, and show your work.