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Salem manufacturing, a US based manufacturer of Gas Turbine Equipment has just concluded negotiations for the sale of a turbine generator To Crown, a British firm for one million pounds. This sale would be on larger side in comparison to the current business of the company. As there are no other customers or the client for the company so it has huge risk for the currency risk. Being the CFO, the following data has been collected on my behalf:
• Spot Exchange rate: $1.5640 per British pound.
• Three month forward rate: $1.5549 per pound
• SALEM’s cost of capital: 16%
• U.K. Annual borrowing interest rate: 12.0% (or 3.0% per quarter)
• U.K. Annual investment interest rate: 10.0% (or 2.5% per quarter)
• U.S. Annual borrowing interest rate: 12.0% ( or 3.0% per quarter)
• U.S. Annual investment interest rate: 8.0% (or 2.0% per quarter)
• December put option in the over-the-counter (bank) market for 1,000,000 British pounds;
Strike price $1.55 (nearly at-the money) 1.5% premium
• December put option in the over-the counter (bank) market for 1,000,000 British pounds:
Strike price $1.51 (out-of-the money) 1.0% premium
• SALEM’s foreign exchange advisory service forecasts that the spot rate in there months will be $1.56 per British pound.
It has been calculated that the minimum acceptable margin was at a sale price of $1,500,000. The budget rate, the lowest acceptable dollar per pound exchange rate, was therefore established at $1.5 per British pound. Any exchange rate below would result in SALEM actually losing money on the transaction.
It is important that the company follows the process of Hedging so that losses could be prevented in long run and the risk for the loss against the currency could be avoided. Hedging refers to a process in which the investment option is put in such a manner that the losses are minimized or reduced to the potential extent. In order to avoid any currency loss as per the data collected it could be analyzed that the company hedges and uses the following option as it could be seen that in case minimum acceptable margin is not kept then the company would be losing in terms of the currency prediction for the dollar against the pound in future
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