International Corporate Finance
U.S. aircraft manufacturer Boeing buys 10 Jet Engines from British Engine Manufacturer Rolls Royce for £50 million payable in one year. Assume the following market conditions:
U.S. interest rate: 6.00% p. a.
U.K interest rate: 6.50% p. a.
Spot exchange rate: $ 1.80/£
Forward exchange rate: $1.75/£ (1-year maturity)
Boeing wants to hedge its currency exposure to protect itself from any adverse market movement. It has three choices:
- Currency Forward contract
- Hedging through investing in the money market
- Currency Options contract
- What should Boeing do if it decides to hedge its exposure through a Currency Forward contract?
In the currency forwards, there is no up-front cost on hedging it should calculate the amount it will pay in future compared to the spot rate. This is an opportunity to hold the rate at constant so as to benefit in the future
What is the dollar amount of the Forward contract?
The total amount in $
= 50, 000,000 *1.75
= $ 87,500,000
- What steps Boeing should take if it decides to hedge its exposure through investing appropriate $ amount in the money market so that the net proceeds from such investment will be sufficient to pay-off £50 million in one year’s time?
The firm should invest in the UK market at the present value pounds payable in that the interest received from the investment should add up the amount paid.
What is the amount of dollar amount that Boeing should invest now to hedge the exposure fully?
Investment = 50,000,000/1.065
= £ 46,948,356.81
- What should Boeing do if it decides to hedge its exposure through Currency Options Contract?
Boeing should pay the premiums; consider the strike price and other transactional prices for the option. In speculation of price changes, they should consider the best available option using the calculation to determine the most profitable by the end of the year.
Assume that in the Options market Call Options on GBP is available with a Strike Price of $ 1.80/£ at a premium of $0.018 per Pound. What will be the total cost of such Options contract to Boeing?
The option premium = (0.018/100) (50,000,000)
The future value = £ 50,000,000 * 1.065
At the expected future spot rate of £ 0 .5555(=1/1.80), which is higher than the exercise of $.0.018
Boeing will exercise its option at the strike price plus the premium
- Use information in © above and calculate the Options pay-off under the following alternative spot exchange rate scenarios:
- $ 1.75/£
- $ 1.80/£
- $ 1.85/£
- $ 1.90/£
Can you calculate the Break-even Strike price of the Call Option at which price there will be zero gain zero loss to Boeing taking into account the cost of the Options Contract?
Break-even price = Strike price + Option premium cost
= $ 1.80+ $0.018
= $ 1.818
Case Problem # 2
Consider the following FX quotations from three banks in US, UK, and Europe:
Citibank in US quote US Dollars per Euro $0.9045 / €
Barclays Bank in UK quotes US Dollars per Pound sterling $1.4443 / £
Deutsche Bank in Germany quotes Euro per Pound sterling €1.6200 / €
- Do you see any anomaly in the quoted rates?
Yes the wordings of Deutsche Bank are different from the signs given
Which currency is undervalued and which currency is overvalued? Explain your answer.
The US Dollar is undervalued
That is $0.9045 / €
€1.6200 / £
This means that $ 1.46529/£ compared to $1.4443 / £ given in the UK market
The Euro is overvalued
That is $0.9045 / €
$1.4443 / £
=1.4443/0.9045 = 1.60
The euro cross rate is €1.6000 but the quoted price is €1.6200
- Explain the concept of ‘Arbitrage opportunities’.
Arbitrage opportunities are mainly buying goods or items in one market and concurrently selling in another market. The profit comes from a temporary difference of buying and selling which is risk free. In our case study, we are dealing with financial markets in US, UK and Germany and we analyzing how the currency can gain or lose in these countries. In situation where the financial markets were perfectly effectual, there would not be any arbitrage opportunities. Nevertheless, markets rarely remain perfect and that is why we have the Arbitrage opportunities.
A market trader has $1,000,000 to play with. Can you design a triangular arbitrage opportunity for the trader and calculate his payoff? Present a diagram explaining the arbitrage and explain the results.
Design a triangular arbitrage opportunity:
|Citi Bank $0.9045 / €|
€ 1,105,583.195 $1,222,314.20
|Barclays Bank $1.4443 / £|
|Deutsche Bank €1.6200 / £|
- Draw the triangle and Identification of the cross rate which is between the translation between deutsche bank and Citi bank.
- The implied cross rate is:-
$0.9045 / € * €1.6200 / £ =1.46529
That is $ 1.46529/£
- In comparison of the cross rate and the given rate, the cross rate is higher which means arbitrage opportunity
- Calculating the pay offs from all the banks starting with the Barclays bank
- In order to maximize on the arbitrage opportunity, selling of dollars ($) to get the pounds (£) from Barclays bank to Deutsche Bank. The trader has $1,000,000
That is $ 1,000,000/ 1.4443 = £ 682,458.78
- From Deutsche Bank , sell the pounds to Euros
€1.6200 / £ * £ 682.458.78 = € 1,105,583.195
- Convert the Euros back to dollars from Deutsche Bank to Citi Bank
€=1,105,583.195/0.9045 = $ 1, 222,314.20
- Total arbitrage amount is equal to:-
Final Amount less the initial amount
$1,222,314.20 – $1,000,000 = $ 222,314.20
The money will gain an interest of $ 222,314.20 which is risk free in a very short duration of time.
- How long do you think such arbitrage opportunities may last?
The arbitrage opportunity will not last for long because the modern technology has reduced the number of these opportunities which were due to lack of communication. When people realize such opportunities, they tend exploit it which increases the prices to match with the other markets.