US-based Ford has an order to sell truck engines to a company in the U.K. The order is invoiced in British pounds (BP) for £5,000,000, for delivery in two months and payment in three months. Three-month currency futures contracts for the BP are currently trading at F3 = $1.5325/£. We’ll ignore transactions costs (fees, commissions, etc.).
a. FULL ESSAY: Explain how/why Ford is exposed to currency risk, and the specific transaction exposure it faces, i.e. what specifically is Ford worried about? Explain what position Ford would take in the BP futures contracts to hedge its currency risk, and explain why it takes that position. You do not need to consider any specific ex-rates or dollar values for this essay.
b. Graph Ford’s position in a fully labeled (with title) futures profit/loss payoff diagram (graph only Ford’s position, not the other side). Note: Please do no copy any of the payoff diagrams directly from the lecture notes.
Assume that the spot ex-rate for the BP in three months is S3 = $1.5075/£.
c. Calculate and report Ford’s total profit or loss on the futures contracts, and state whether it is a profit or loss.
d. Calculate and report the total dollar proceeds from selling the £5,000,000 at the spot rate.
e. Calculate Ford’s total proceeds (profit/loss on the futures contract and proceeds from the spot market).
Assume that the spot ex-rate for the BP in three months is S3 = $1.5575/£.
Repeat steps c, d and e and label the answers f, g and h.
i. Summarize the main conclusions of this analysis in a complete and convincing essay of at least one full paragraph (100-200 words), referring specifically to your numerical results above. Imagine that you are explaining to your CEO why currency futures should be considered as a risk management tool for your firm.