Question 45 (6 points)

MINICASE: Rolls-Royce Exposure to Exchange Risk :

Rolls-Royce, a UK-based company, sold 15 engines to the American company, Boeing, for $2million each. The two companies agreed that the total amount of $30 million will be paid in six

months.

Rolls-Royce, like any MNC, would prefer to hedge against the exchange risk.

The current spot exchange rate is $1.05/ and six-month forward exchange rate is $1.10/ at the moment. Rolls-Royce can buy a six-month put option on U.S. dollars with a strike price of 0.95/$ for a premium of 0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the UK and 3.0% in the U.S.

a. Compute the guaranteed pound proceeds

from the American sale if Rolls-Royce decides to hedge using a forward contract.

b. If Rolls-Royce decides to hedge using money market instruments, what action does Rolls-Royce need to take? What would be the guaranteed pound proceeds from the American sale in this case?

c. If Rolls-Royce decides to hedge using put

options on U.S. dollars, what would be the

'expected' pound proceeds from the American sale? Assume that Rolls-Royce regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

d. At what future spot exchange rate do you think Rolls-Royce will be indifferent between the option and money market hedge?