Current one-year interest rate for USD LIBOR: 5.25%
Current one-year interest rate for Sterling (UK) LIBOR: 4.25%
Current spot ex-rate (S): = $1.5200/£
Current one-year forward rate (F) = $1.5428/£
IBM (a US-based MNC) has a £10M account receivable in one year from a UK company for some computer equipment it will sell to a British firm.
BP put options are available for $0.0135/£ at an exercise (strike) price of $1.5300/£ and IBM uses these BP put options to hedge its ex-rate risk.
f. Calculate and report the cost of the options, including the opportunity cost.
g. Calculate IBM’s total dollar proceeds and effective ex-rate in one year for the following spot ex-rates in one year: $1.5800/£, $1.5500/£, $1.5000/£ and $1.4750/£ (in that exact order, please do not reverse and please do not combine any of the ex-rates). Show 4 separate parts for each ex-rate like on the last problem set: i) the net gain or loss on the options including the opportunity cost, ii) dollar proceeds at the spot rate, iii) the net total dollar proceeds of the order that includes the proceeds from selling the BPs at the spot rate and the profit or loss on the options contracts, and iv) the effective ex-rate. Assume an opportunity cost of 5.25% for one year to buy the options and make that part of your analysis.
h. ESSAY: Summarize the main results of using a put option to hedge currency risk in a complete essay of a full paragraph or more, and refer specifically to your numerical results from part g.
e. Show a carefully labeled and titled profit/loss diagram for these put options. (Please do not copy payoff diagrams directly from the lecture notes.)