Kelvin just purchased £15.2 million goods from a British exporter on credit due 90 days from today. The spot exchange rate is $1.21/£. The 90-day interest rates in the U.S. and the UK are 1 and 1.5 percent respectively. The 90-day forward rate on the pound is $1.2090/£. A 3-month call at strike price of $1.20/£ can be purchased at a premium of $0.016. A 3-month put option at strike price of $1.20/£ can be purchased at a premium of $0.018 and can be sold at a premium of $.017. Assuming in 90 days the exchange rate will be either $1.20/£ or $1.25/£. Analyze the following scenarios:
a) What is the amount of payables in U.S. dollars assuming the firm hedges with a forward contract?
b) What is the amount of payables in U.S. dollars assuming the firm buys call options to hedge?
c) What is the payoff of a collar involving a long call and short put at the same strike price of $1.20/£
d) Graph above scenarios in EXCEL within the assumed ranges for the exchange rates.
e) What is your recommendation as a treasurer of the firm to the Board of the Directors of Kelvin as to the effectiveness of any one of the approaches you take in hedging the firm’s exposure to foreign exchange risk?