Identify and explain the three main categories of risk that a company will be exposed to from movements in exchange rates. Illustrate your answer with an example for each category.

Assume today is 1st July 2022.

You are the treasurer of The Plastic Bottles Company in the UK, and you are advised that the company is likely to purchase new equipment to improve the productivity of the manufacturing. The equipment will be manufactured in the US and will cost $12,000,000.

The finance director has asked you to recommend action(s) in order to hedge the purchase as the has been some volatility in the exchange rate between sterling and the US dollar over the last 12 months. He tells you that the equipment could be ordered immediately for delivery in three months and payment in six months. However, at the management meeting, there were discussions about postponing the upgrading plans due to the potential release of new equipment being developed that may be available towards the end of the year.

You Obtain the following market data/information.:

Spot rate $/£ $1.2300 – $1.2350

3m Forward Rate $1.2325 – $1.2375

6m Forward Rate $1.2350 – $1.2400

A call option is available to purchase dollars at an exercise rate of $1.2300, the premium is £0.012101 per $. Current market speculation is that sterling will apricate over the next six months as the UK economy grows at a faster pace compared to the US economy.

b) Calculate the cost of purchasing the equipment if a forward contract is used to hedge the transaction exposure.

c) Calculate the all-in cost of purchasing the equipment if the option contract is used and the exchange rate has moved to:

i) $1.2000

ii) $1.2300

iii) $1.2700

d) For each of the scenarios in part (b) evaluate whether it would have been better to hedge with a forward contract or an option contract, and fully explain your answers.

e) If the contract was cancelled, fully explain the consequences if you had hedged by using the forward contract or the option contract. You should illustrate your answer with appropriate numerical examples.

f) You also know that Money Market rates for The Plastic Bottles Company

Deposit Borrowing

The annual interest rate for GBP is 4.00% 6.00%

Annual interest rate for USD 0.50% 2.50%

Calculate the expected net sterling payments in six months using a money market hedge.

g) Evaluate the use of forwarding contract and currency options to hedge transaction risk and advise the management of The Plastic Bottles Company on the best course of action in this case.