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Hedging using Foreign Currency Derivatives of SALEM Manufacturing a U.S. based manufacturer of gas turbine equipment.

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For this assignment, you’ll read about Salem Manufacturing and answer the following question in 2 pages. Four alternatives are available to Salem to manage the exposure: 1. Remain un-hedged. 2. Hedge in the forward market. 3. Hedge in the money market. 4. Hedge in the options market. What should Salem do? Be as complete as possible. Hedging using Foreign Currency Derivatives Shiela Penny is the Chief Financial Officer [CFO] of SALEM Manufacturing, a U.S. based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine gene...

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Question Preview:

For this assignment, you’ll read about Salem Manufacturing and answer the following question in 2 pages. Four alternatives are available to Salem to manage the exposure: 1. Remain un-hedged. 2. Hedge in the forward market. 3. Hedge in the money market. 4. Hedge in the options market. What should Salem do? Be as complete as possible. Hedging using Foreign Currency Derivatives Shiela Penny is the Chief Financial Officer [CFO] of SALEM Manufacturing, a U.S. based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm for One million pounds. This single sale is quite large in relation to SALEM’s present business. SALEM has no other current foreign customers, so the currency risk of this sale is of particular concern. The sale is made in September with payment due three months later in December. Shiela Penny has collected the following financial market information for the analysis of her currency exposure problem: • 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. Like many manufacturing firms, SALEM operates on relatively narrow margins. Although Ms. Penny and SALEM would be very happy if the pound appreciated versus the dollars, concerns center on the possibility that the pound will fall. When Ms. Penny budgeted this specific contract, she determined 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.

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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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