cross currency exchange rates and arbitrage opportunities


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:

a.    Currency Forward contract
b.    Hedging through investing in the money market
c.    Currency Options contract

Required:

a.    What should Boeing do if it decides to hedge its exposure through a Currency Forward contract?  What is the dollar amount of the Forward contract?

b.    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? What is the amount of dollar amount that Boeing should invest now to hedge the exposure fully?

c.    What should Boeing do if it decides to hedge its exposure through Currency Options Contract? 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?

d.    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/£

Bonus Question: (optional)


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?


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