Question

Use the following information to answer questions 1-5 Dayton Manufacturing’s Transaction Exposure Scout Finch is the CFO of Dayton, a US-based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm, for £1 million. This single sale is quite large in relation to Dayton’s present business, so the currency risk of this sale if of particular concern. The sale is made in March with payment due three months later in June. Scout has collected the following financial information: Spot rate: 1.74 $/ £ 3-month forward rate: 1.754 $/ £ UK 3-month borrowing rate: 10% a year. UK 3-month lending rate: 8% a year. US 3-month borrowing rate: 8% a year. US 3-month lending rate: 6% a year. June put option for £1m: Strike $1.75, premium 1.5% * Note that the interest rates given are in annual terms but payment is due in three months. Dayton’s advisory service forecasts that the spot rate in 3 months will be 1.76 $/ £ Flag question: Question 1 Question 11 pts Calculate the dollar value of the unhedged position/receivable in three months assuming that the Spot rate in 3 months is $1.76. Explain your calculations (in your notes). Flag question: Question 2 Question 21 pts Calculate the dollar value of the position if Dayton wishes to hedge its transaction exposure in the forward market. Explain the hedging strategy and calculations (for yourself). Flag question: Question 3 Question 31 pts Calculate the dollar value of the position if Dayton wishes to hedge its transaction exposure in the money market. Explain the hedging strategy and calculations (for yourself). Flag question: Question 4 Question 41 pts Calculate the dollar value of the position if Dayton wishes to hedge its transaction exposure in the options market. Explain the hedging strategy and calculations. Assume the spot rate at maturity is less than the strike price of the option. Flag question: Question 5 Question 51 pts Calculate the dollar value of the position if Dayton wishes to hedge its transaction exposure in the options market. Explain the hedging strategy and calculations. Assume the spot price at maturity is 1.76$/£. I need mostly 4 and 5 answered

Answer 1

4. If the spot rate at maturity is less than the strike price of the option, the dollar value of the position when hedging using the options market would be $1,750,000.

5. If the spot price at maturity is $1.76/£, the dollar value of the position when hedging using the options market would be $1,760,000.

Step-by-step explanation:

For question 4, if the spot rate at maturity is below the strike price ($1.75), Dayton would exercise the put option to sell pounds at the higher strike price, resulting in a dollar value of $1,750,000. This action protects the receivable from adverse currency movements.

Regarding question 5, if the spot rate at maturity is $1.76/£, above the strike price, Dayton would let the put option expire unexercised as it would be more profitable to exchange currency at the spot market rate. Thus, the dollar value of the position would be the value of the sale at the prevailing spot rate, totaling $1,760,000.

Utilizing put options allows Dayton to protect against unfavorable exchange rate movements. If the spot rate is below the strike price, the put option secures a minimum dollar value, while if the spot rate is above the strike price, they can capitalize on the more favorable spot market rate, rendering the option unnecessary.

Answer 2

Question 4:

1. Exercise put option at the strike price of $1.75.

2. Dollar value of hedged position = £1 million * $1.75 = $1,750,000.

3. This hedges against adverse exchange rate movements when the spot rate at maturity is less than the strike price.

Question 5:

1. Spot rate at maturity is $1.76, no need to exercise put option.

2. Dollar value of hedged position remains £1 million * $1.76 = $1,760,000.

3. The option premium is treated as the cost of the hedging strategy in this scenario.

Step-by-step explanation:

In Question 4, Dayton chooses to hedge its transaction exposure in the options market by purchasing a put option. This financial instrument allows Dayton to sell £1 million at a predetermined exchange rate of $1.75 per pound, offering protection if the spot rate at maturity falls below this level. The calculation involves dividing the transaction amount by the strike price and subtracting the premium. Consequently, the dollar value of the hedged position is $1,758,065. This strategy ensures that Dayton is safeguarded against potential adverse movements in the exchange rate, limiting the downside risk associated with the transaction.

Moving to Question 5, Dayton opts for hedging in the options market again, but this time using a call option. By purchasing a call option with a strike price of $1.75, Dayton has the right to buy £1 million at this predetermined rate, providing protection if the spot rate at maturity exceeds $1.75 per pound. The calculation involves dividing the transaction amount by the spot rate at maturity and subtracting the premium, resulting in a dollar value of $1,761,905.

This approach safeguards Dayton from unfavorable exchange rate movements while allowing for potential gains if the spot rate increases. Both options strategies effectively mitigate the impact of currency risk, providing Dayton with financial stability in its international transactions.