Section 1: Hedging (20 marks; no word limit) Mudbury is a UK company. It makes milk chocolate. It owes USD200,000 (payables). It has ordered a machine that filters cocoa powder, from an American company. It will receive the machine in six (6) months. Thus, it must pay the American company USD200,000 when it gets the machine in six months, at the latest. But Mudbury is worried about the USD appreciating in value against the British pound, GBP. A few months ago, GBP/USD was USD1.35. Today, the spot rate is as in Table 1 below. Mudbury fears the USD will continue to strengthen until the exchange rate is USD1.10. Mudbury is considering ways to hedge against the USD appreciating against the GBP, with related information in Table 1. Table 1: Information available to the company about hedging strategies Questions Assess the hedging options (round any number to the nearest whole: e.g., if GBP30,020.32, then answer 'GBP30,020'): 1. Briefly: why is the company afraid of the continued strengthening of the US against the GBP, that is, why does it fear the GBP/USD rate going to USD1.10? 2. How many GBP will it cost the company to use a forward hedge? 3. How many GBP will it cost the company to use a money-market hedge? Also explain the steps that the company will take to perform this money-market hedge. 4. How many GBP will it cost the company to use a call option to buy USD, if in six months (i) the spot rate is GBP/USD = USD1.25 (a 15\% probability of this occurring), or (ii) the spot rate is GBP/USD = USD1.20 (a 25% probability of this occurring), or (iii) the spot rate is GBP/USD = USD1.15 (a 30% probability of this occurring), or (iv) the spot rate is GBP/USD = USD1.10 (a 30% probability of this occurring) Evaluate whether the company will exercise the option in each case. Use Table 2 below in your submission document (or a suitable variation of it, if you prefer). Table 2: Various spot rate scenarios, the probabilities these spot rates will occur, and the costs of using the option 5. Using Table 2, calculate the expected value of GBP it will cost the company to use the option. Using Table 2, calculate the expected value of GBP it will cost the company to not do anything but use the spot rate in six months. 6. Of all the above (forward, money market, options, do nothing and use the spot market), evaluate which would be the best choice for the company. Why? 7. Pick any two (2) 'internal hedging methods' (other than 'doing nothing') and propose how the company could use them. Refer to Week 7's notes on hedging. Section 1: Hedging (20 marks; no word limit) Mudbury is a UK company. It makes milk chocolate. It owes USD200,000 (payables). It has ordered a machine that filters cocoa powder, from an American company. It will receive the machine in six (6) months. Thus, it must pay the American company USD200,000 when it gets the machine in six months, at the latest. But Mudbury is worried about the USD appreciating in value against the British pound, GBP. A few months ago, GBP/USD was USD1.35. Today, the spot rate is as in Table 1 below. Mudbury fears the USD will continue to strengthen until the exchange rate is USD1.10. Mudbury is considering ways to hedge against the USD appreciating against the GBP, with related information in Table 1. Table 1: Information available to the company about hedging strategies Questions Assess the hedging options (round any number to the nearest whole: e.g., if GBP30,020.32, then answer 'GBP30,020'): 1. Briefly: why is the company afraid of the continued strengthening of the US against the GBP, that is, why does it fear the GBP/USD rate going to USD1.10? 2. How many GBP will it cost the company to use a forward hedge? 3. How many GBP will it cost the company to use a money-market hedge? Also explain the steps that the company will take to perform this money-market hedge. 4. How many GBP will it cost the company to use a call option to buy USD, if in six months (i) the spot rate is GBP/USD = USD1.25 (a 15\% probability of this occurring), or (ii) the spot rate is GBP/USD = USD1.20 (a 25% probability of this occurring), or (iii) the spot rate is GBP/USD = USD1.15 (a 30% probability of this occurring), or (iv) the spot rate is GBP/USD = USD1.10 (a 30% probability of this occurring) Evaluate whether the company will exercise the option in each case. Use Table 2 below in your submission document (or a suitable variation of it, if you prefer). Table 2: Various spot rate scenarios, the probabilities these spot rates will occur, and the costs of using the option 5. Using Table 2, calculate the expected value of GBP it will cost the company to use the option. Using Table 2, calculate the expected value of GBP it will cost the company to not do anything but use the spot rate in six months. 6. Of all the above (forward, money market, options, do nothing and use the spot market), evaluate which would be the best choice for the company. Why? 7. Pick any two (2) 'internal hedging methods' (other than 'doing nothing') and propose how the company could use them. Refer to Week 7's notes on hedging
