Dozier: Foreign Exchange Market and Forward Contract

Dozier Industries has three options to choose from when deciding on the best way to handle their first non-US dollar denominated receivable:

  1. Entering into a forward contract in which Dozier would sell forward British Pounds.
  2. Execute a spot market transaction to create a synthetic forward hedge.
  3. Do not hedge against any fluctuations between the Pound and the Dollar.

For the purpose of the analysis, there are several assumptions made which are pertinent to the analysis that follows (see appendix).

Forward Contract Hedge

The first option available to Dozier Management to hedge the risk of the Great British Pound (GBP) depreciating against the United States Dollar (USD) is to enter into a contract to sell forward ? 1,057,500 for USD in 90 days. Therefore, on April 14th, when Dozier receives the remaining GBP from the security system contract, it would be required to deliver these GBP to the counterparty of the forward contract. This option would make the firm immune to any fluctuations in the value of GBP relative to USD over the next 90 days as the firm would lock in the USD/GBP exchange rate for their receivable of ? ,057,500.

At the current 3-month forward rates of (1. 4198 USD/GBP), Dozier would capture guaranteed proceeds of $1,501,438. 50. Dozier also received ? 117,500 as deposit for the contract. The firm could sell this deposit on the spot foreign exchange market at the current rate of 1. 437 USD/GBP and receive $168,847. 50. Investing the proceeds of the deposit in a U. S. money market account would yield $171,988. 00 in 90 days.

It is important to note that since the contract was settled on December 3rd, the GBP depreciated by over 3% (from (1. 820 to 1. 437 USD/GBP). As a result of this movement, the USD value of the deposit was reduced by the same 3% from $174,135. 00 to $168,847. 50.

Under the strategy of using the forward contract hedge, the firm would be assured of receiving a total of $1,673,426. 50 ($1,501,438. 50 plus $171,988. 00). Given the total cost of the project of $1,642,783, the firm would realize a profit of $30,643. 50, a margin of 1. 87%. This profit margin would be significantly below the projected 6% return. Spot Market Hedge

An alternative to the forward contract hedge is Dozier could create a matching liability for the GBP receivable by borrowing GBP from the bank, immediately exchanging the GBP for USD in the spot foreign exchange market and then investing the USD proceeds in a three month deposit. At the time the receivable comes due, Dozier would use the GBP proceeds to repay the liability and keep the USD amount of the three month profit. These series of transactions would eliminate the risk of the depreciation of the Pound. GBP funding is available at a rate of 15% (13. 50% GBP prime rate plus 150 basis point credit spread).

To create a GBP liability of ? 1,057,500 GBP in 90 days, the firm would need to borrow its present value of ? 1,021,188. 50. The firm would then receive $1,467,447. 88 at the current exchange rate. As the USD investment would be over $1. 0 million it would be classified as a large deposit and qualify for the premium interest rate. As in the previous scenario, Dozier would immediately exchange the ? 117,500 deposit into $168,847. 50.

The total proceeds of $1,636,295. 38 could then be invested in a deposit bearing 8%, earning interest of $31,787. 57 over 90 days. The firm would receive a total of $1,668,082. 4 from the initial deposit, the principle and interest in the three month investment. Given the project costs stated above, the firm would realize a profit of $25,299. 94, representing a margin of 1. 54%.

Spot Market Hedge The final option available to Dozier Management is to leave the 1,057,500 GBP receivable un-hedged. If the GBP were to appreciate against the USD over the next 90 days, Dozier would reap the full benefit of this appreciation. Conversely, should the GBP depreciate versus the USD over the next 90 days, Dozier would suffer a loss equal to the percent depreciation of the pound to the dollar.

In a scenario where the USD/GDP exchange rate moves by ±10%, the Dozier’s profits would range between negative $96,471. 13 (or 5. 9% of cost, making the project a loss) and $207,819. 16 (or 12. 65% of cost, effectively doubling the profit margin). Conclusion Dozier can capture a profit through both of the hedging strategies albeit it being smaller than the target six percent originally built into the bid. An un-hedged position is unacceptable due to the firm’s recent financial difficulties – it is critical that Dozier profits from this initial venture into this new market.

While leaving the receivable un-hedged alternative does offer the greatest potential profit at the current prevailing FX rates, these profits are not guaranteed (see appendix for profit/loss possibilities given GBP/USD FX fluctuations). Given the importance of locking in a profit and the uncertainty of the GBP/USD future exchange rates, we recommend Dozier hedges the ? 1,057,500 receivable by exchange rate in Appendix Assumptions:

  • All transactions are executed immediately.
  • All transaction costs surrounding the forward contract are negligible.
  • All rates given in Exhibit 4 will not fluctuate over the 90 day time p.

Deposits over $1 million are eligible for the three month deposit rate. Calculation of Profits:

  • Spot Market Hedge Deposit Amount $ 168,847. 50
  • Interest Received $ 28,507. 45
  • Principal Amount $ 1,467,447. 88
  • Total $ 1,664,802. 82
  • Cost of Project $ 1,642,783. 00
  • Interest on Initial Deposit $ 3,280. 12
  • Net Profit on Project $ 25,299. 95
  • Profit Margin on Project1. 54%
  • Currency Forward Hedge Receivable GBP $ 1,057,500. 00
  • Short GBP $ (1,057,500. 00)
  • Long USD  3 month Fwd $ 1,501,438. 50
  • Deposit $ 168,847. 50
  • Cost of Project $ 1,642,783. 00
  • Interest on Initial Deposit $ 3,140. 50
  • Net Profit on Project $ 30,643. 50
  • Profit Margin on Project1. 87%

Profit Margin Scenario Analysis FX Rates% ChgUSD EquivalentCost of ProjectDepositProfit/LossProfit Margin 1. 30 -10. 0% $ 1,374,323. 87

Notes:

  • All numbers rounded to the nearest one-hundredth decimal place.
  • No probability weighting given to each scenario.

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