Dozier: Options
Dozier
Since the acceptance of Dozier Industries’ bid, the company CFO has been exploring the methods available to best manage the exchange risk associated with the award payment being dispersed in British Pounds (GBP). He originally considered a forward contract or a spot contract, but is now investigating how currency options could help hedge against uncertain foreign exchange exposure. The CFO needs to decide whether or not options contracts might provide some benefit to hedge the currency risk. As of 1/14/86, Dozier has received a 10% deposit of the total contract value of £1,175,000.00. At the 1/13/86 exchange rate, this value translates to $170,140.00. The remaining £1,057,500.00 is a receivable that Dozier currently holds and is subject exchange rate risk. In order to hedge against the exchange rate between US dollars (USD) and GBP going down, Dozier could purchase put contracts. These put contracts would appreciate as Dozier’s receivable loses value on the USD after the exchange rate falls below the strike price of the put contracts. If the put contracts are purchased at the right strike price, Dozier would have a guaranteed minimum profit.
Dozier could also sell call options on the USD/GBP exchange rate. These calls would increase the minimum profit that Dozier would receive by the amount of money gained from the sale of the call contracts. However, this would also limit their upside. If the exchange rate were to rise above the strike price of the calls then Dozier’s gains on their receivable would be offset by like losses on the calls. This would set a maximum profit that Dozier could achieve but would also increase the lowest profit they could obtain on this project. Given that this project is a short time frame, 3 months, and that the exchange rate is expected to drop in the future (deduced by 3 month forward rate being lower than the spot rate) we think it would be a smart move by Dozier to sell call contracts in order to increase their
Since the acceptance of Dozier Industries’ bid, the company CFO has been exploring the methods available to best manage the exchange risk associated with the award payment being dispersed in British Pounds (GBP). He originally considered a forward contract or a spot contract, but is now investigating how currency options could help hedge against uncertain foreign exchange exposure. The CFO needs to decide whether or not options contracts might provide some benefit to hedge the currency risk. As of 1/14/86, Dozier has received a 10% deposit of the total contract value of £1,175,000.00. At the 1/13/86 exchange rate, this value translates to $170,140.00. The remaining £1,057,500.00 is a receivable that Dozier currently holds and is subject exchange rate risk. In order to hedge against the exchange rate between US dollars (USD) and GBP going down, Dozier could purchase put contracts. These put contracts would appreciate as Dozier’s receivable loses value on the USD after the exchange rate falls below the strike price of the put contracts. If the put contracts are purchased at the right strike price, Dozier would have a guaranteed minimum profit.
Dozier could also sell call options on the USD/GBP exchange rate. These calls would increase the minimum profit that Dozier would receive by the amount of money gained from the sale of the call contracts. However, this would also limit their upside. If the exchange rate were to rise above the strike price of the calls then Dozier’s gains on their receivable would be offset by like losses on the calls. This would set a maximum profit that Dozier could achieve but would also increase the lowest profit they could obtain on this project. Given that this project is a short time frame, 3 months, and that the exchange rate is expected to drop in the future (deduced by 3 month forward rate being lower than the spot rate) we think it would be a smart move by Dozier to sell call contracts in order to increase their