Reference no: EM133113546
MINICASE: Rolls-Royce Exposure to Exchange Risk
Rolls-Royce, a UK-based company, sold 15 engines to the American company, Boeing, for $2 million 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?
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