Evaluate each of the different alternatives. Justify your assumptions and argue which is the best one for Dozier. After their bid was accepted, Dozier has three options to choose from. Of the three choices, the 1st alternative yields the most profit. However, the profit from alternative 1 cannot be guaranteed, and it is much more volatile. The company wants to expand its market to the U. K. and also guarantee the profit (while minimizing exchange risk). Therefore, alternative 2, which has a higher profit margin than alternative 3 is the best hedging choice for Dozier. Alternative 1
Dollar value of the balance $1,505,086. 88 $ 1,501,438. 5 $1,493,995. 00 Dollar value of the contract $1,677,311. 33 $1,673,663. 00 $1,666,219. 73 Total cost $1,642,783. 00 $1,642,783. 00 $1,642,783. 00 Profit $34,528. 32 $30880 $ 23,437. 00 Percent of Profit 2. 10% 1. 88% 1. 43% Cost of Hedge N/A -1. 20% -1. 70% The detailed calculation is shown below. Alternative 1: Do Nothing Dozier would choose to remain unhedged, and expose itself to currency risk. We assume the company will exchange the 10% deposit into dollars and deposit into the U. S. anks directly. The company can obtain interest revenue from this part of deposit. The spot pound rate in U. S. dollars on January 14 is 1. 437. The company can get ? 117,500 ? 1. 437 = $168847. 5 when they exchange the deposit. Three-month deposits interest rate in the U. S. is 8% annually. Therefore, the interest rate would be 0. 08/4=2%. The company can get $168847. 5 ? 1. 02 = $172224. 5 from the 10% deposit. The company will receive GBP 1. 0575 million on April 14,1986. The exchange rate on April 14 remains unknown. However, the pound has weakened over the previous six weeks.
CFO, Rothschild was also concerned that the value of the pound might depreciate even further during the next 90 days. We can set three possible rates with different possibilities. According to Exhibit 5, the 3-month forward rate is 1. 4198. This is the scenario that has the highest probability of occurring in the future because it is the most reasonable spot rate on April 14. This is the base case from which to measure the other two alternatives. We can also run the regression (see appendix, graph 1) on the recent eight weeks and get the exchange rate on April 14, as the worst case.
Another regression can be run based on the half year exchange rate (see appendix, graph 2). This case can be set as the best one which shows long term data. Receivables Exchange Rate Revenue Probability Base Case ?1,057,500 1. 4198 $ 1,501,438. 50 50% Worst Case ?1,057,500 1. 3617 $1,439,997. 75 25% Best Case ?1,057,500 1. 4917 $1,577,472. 75 25% The total expected revenue from receivables would be: Base Case Revenue ? Probability + Worst Case Revenue ? Probability + Best Case Revenue ? Probability = 1,505,086. 88. Therefore, Revenue from Receivables $ 1,505,086. 88 Revenue from Deposit $172224. 45
Total Expected Revenue $ 1,677,311. 33 Total Cost $1,642,783. 00 Profit $34,528. 32 Percentage of Profit 2. 10% We can also perform break-even analysis here. The exchange rate would be 1. 3906 when the profit is zero. Therefore, if the pound depreciate to 1. 3906, the company would suffer a loss for this contract. Alternative 2: If Dozier sells pounds forward 90 days Dozier would incur an obligation to deliver pounds 90 days from 1/14/86 at the rate of 1. 437. This would ensure that Dozier would receive a certain amount of money, regardless the change of exchange rate. The 3-Month Forward Rate in U. S. Dollars on 1/14/86 is 1. 4198 and the balance is GBP 1. 0575 million. Thus, Dozier would receive 1. 4198 ? ?1. 0575 million = $1501438. 5 after three months. As we discuss above, the company can get 168847. 5 ? 1. 02 = $172224. 5 dollars from the 10% deposit. Therefore, the actual revenue of the contract is 1501439 + 172224. 5 =$1673663. The total cost is $1642783. Thus the profit is 1673663 – 1642783 = $30880. The percent of profit is 30880/1642783 = 1. 88% If the rate remains the same as 1. 437, the rest pounds has the value of 1. 437 ? ?1. 0575 =1519627. 5 million. The cost of hedge is (1501438. 5 – 1519627. )/1519627. 5 = -1. 2% Alternative 3: If Dozier secures a 90-day pound loan Dozier can also do a spot hedge, which worked similarly in that it also created a pound obligation 90 days. Dozier would borrow pounds from bank and exchange the proceeds into dollars at the spot rate of 1. 4198. Dozier would use its pound receipts, ? 1. 0575 million, to repay the loan. The rate of loan would be at 1. 5% above the U. K. prime rate. Since the loan rate for three months is (1. 5% + 13. 5%)/4=3. 75%, Dozier could receive ? 1. 0575 million/ (1+3. 75%) = ? 1019277 on 1/14/86. Then he would exchange them to dollars.
With the spot transaction at 1/14/86, Dozier would get ? 1019277 ? 1. 437 =$ 1464701. 2 on 1/14/86. To get more profit, Dozier would deposit dollars. At end of three months, they would receive $ 1464701. 2 ? (1+8%/4) = $1493995 for ? 1. 0575 million. As we discuss above, the company can get 168847. 5 ? 1. 02 = $172224. 5 dollars from the 10% deposit. Thus, the actual revenue of the contract is 1493995 + 172224. 5 =$1666219. 73. The total cost is $1642783. Ergo the profit is 1666219. 73 – 1642783 =$ 23437. The percent of profit is 23437/1642783 = 1. 43%. The cost of hedge is (1493995 – 1519627. 5 )/1519627. = -1. 7% 2. What is the relation between the forward rate,the spot rate and the interest rates in the US and the UK? Below are the formulas from the suggested reading. It can show the relationship between the forward rate,the spot rate and the interest rates. Forward rate in U. S. : Forward rate in U. K. : If we divide forward rate in U. S. by forward rate in U. K. , we can get formula below: Generally, the relationship between currency spot rates and futures rates are based on interest rate parity, in which the exchange rate is determined by the relative interest rates, and the expected future spot rate.
From the formulas above, we can see that if the US risk-free rate is less than the British pound rate, the futures exchange rate will be less than the current spot exchange rate. Relative to the spot rate, the forward rate tells you whether interest rates in one currency are higher or lower than those in the other currency. The international Fisher effect suggests the currency of the country with the higher nominal interest rate is expected to depreciate against the currency of the country with the lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation.
Are there alternative ways for Dozier to protect itself from currency risk? Yes. There are five alternatives for Dozier to protect itself from currency risk. First, Dozier could offset the pound exchange risk by hedging with options. Calls would be used if the risk is an upward trend in price, while puts are used if the risk is a downward trend. If the risk was a depreciation of the pound, Dozier would need to buy put options on pounds. If pounds were to depreciate at the time Dozier receives its pound revenue, then Dozier would exercise its right and thereby effectively obtain a higher exchange rate.
However, if the pound was to appreciate instead, Dozier would then let the contract expire and exchange its pounds in the spot market at the higher exchange rate. The options market allows traders to experience unlimited favorable movements while limiting losses. This feature is unique to options, unlike the forward or futures contracts where the trader has to forego favorable currency rate movements, plus there are also no limits to losses. The advantages of options over forwards and futures are the limited downside risk and the flexibility and variety of strategies made possible.
Also, in options there is neither the initial margin nor the daily variation margin since the position is not marked to market. This relieves traders from potential cash flow problems. Options are however, more expensive because they are much more flexible compared to forwards or futures. The option price is therefore its disadvantage. Another alternative for Dozier to protect itself from currency risk would be to use profits generated in British pounds to buy durable goods which are then sold in the US in dollars. For example, British beer.
Presumably, the beer industry has a low beta since most people are going to drink, regardless of economic standings. There may even be a tendency for people to drink more during hard economic times. If Dozier were to purchase British beer in pounds, the value would be retained when resold in the US, thus protecting the firm from exchange risk. The primary cost associated with this may be tariffs and other taxes on imports to the U. S. Third, similar to the alternative above, Dozier could direct profits earned in British pounds into other U.
K. investments. From the case, it is believed that the company wants to continue its international growth. The company can use the profits earned to expand the overseas market. Holding a large portfolio of international units can in the long run, reduce unsystematic risk isolated in the U. S. Fourth, because the pound might depreciate further during the next 90 days, Dozier can accelerate the completion of the project to offset currency risk (predicted depreciation of the pound) by collecting payment prior to the agreed upon date.
Finally, the company can benefit from currency swap. It is a foreign-exchange agreement between two institutions to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are motivated by comparative advantage. For instance, if Dozier needed to acquire pounds and a U. K. company needed to acquire dollars, these two parties could arrange to swap currencies by establishing an interest rate, an agreed upon amount, and a maturity date.
These currency swaps are negotiable for at least 10 years making them a very flexible method of foreign exchange. Additionally, since swaps are considered a foreign exchange transaction, they are not required to be listed on a firm’s balance sheet. 4. Should Dozier diversify its currency risk? Does it have a comparative advantage in remaining unhedged? Yes, controlling the currency risk is an important instrument for controlling and improving performance of international investments. In remaining unhedged Dozier may not necessarily have an advantage.
While option 1 was calculated to be the most profitable, this depends on the exchange rates remaining relatively high. The exchange rates will fluctuate. The value of the dollar could increase or the pound could decrease leading to losses. If it goes below 1. 3906, the company would suffer a loss. It is the first time that Dozier is expanding into a foreign country. For Dozier to continue to expand into foreign markets, it is essential that cash flows are generated. Hedging offers Dozier exchange rate risk protection in the vent the value of the British pound falls. It would eliminate the risk and guarantee the necessary cash flows. For the same reasons however, it may be Dozier’s best interest to remain unhedged. If they already planned for a 6% profit margin, exposing themselves to more risk may be the only way to get a this return. A riskier, unhedged position may be further incentivised by a principal agent problem between Rothschild and the CEO. It is not explicitly stated, but as the CFO, Rothschild’s job may be on the line if he does not perform.
Therefore, the added risk in order to cover for past 6 week’s exchange losses may be his last hope. It will not cost him any more to take on the additional risk if he is already facing a high probability of losing his job. Agency costs aside, the question boils down to this: Is a high probability of a small profit better than a small probability of a big profit. Considering this is their first international project, it might be best to go with what is certain, taking small steps, and learn from their mistakes going forward into future projects.