Second the loan proceeds can be substituted for an

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Second, the loan proceeds can be substituted for an equal dollar loan that Trident would have otherwise taken for working capital needs at a rate of 8.0% p.a. Third, the loan proceeds can be invested in the firm itself in which case the cost of capital is 12.0% p.a.
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Trident’s Transaction Exposure Because the proceeds in 3 months from the forward hedge will be $1,754,000, the money market hedge is superior to the forward hedge if the proceeds are used to replace a dollar loan (8%) or conduct general business operations (12%) The forward hedge would be preferable if the loan proceeds are invested at (6%) We will assume the cost of capital as the reinvestment rate Received today Invested in Rate Future value in 3 months $1,720,976 Treasury bill 6% p.a. or 1.5%/quarter $1,746,791 $1,720,976 Debt cost 8% p.a. or 2.0%/quarter $1,755,396 $1,720,976 Cost of capital 12% p.a. or 3.0%/quarter $1,772,605
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Trident’s Transaction Exposure A breakeven investment rate can be calculated between forward and money market hedge 0.0192 r $1,754,000 r) (1 x $1,720,976 proceeds) (forward rate) (1 x proceeds) (Loan = = + = + 7.68% 100 x 90 360 x 0192 . 0 = To convert this 3 month rate to an annual rate, In other words, if Trident can invest the loan proceeds at a rate equal to or greater than 7.68% p.a. then the money market hedge will be superior to the forward hedge
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Trident’s Transaction Exposure 1.68 1.70 1.74 1.76 1.72 1.82 1.80 1.78 1.86 1.84 Value in US dollars of Trident’s £1,000,000 A/R 1.68 Ending spot exchange rate (US$/£) 1.70 1.72 1.74 1.76 1.78 1.80 1.82 1.84 Money market hedge yields $1,772,605 Forward rate is $1.7540/£ Forward contract hedge yields $1,754,000 Uncovered yields whatever the ending spot rate is in 90 days
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Trident’s Transaction Exposure Futures market hedge Trident could also cover the £1,000,000 exposure by selling futures contracts now at say $1.7540/£ - most futures contracts are not delivered therefore instead of spot rate you would have purchase price of the futures contract below If spot rate is $1.7600/£ then the result of futures position is: Value at maturity (Short position) = – Notional principal (Spot – Futures) Value at maturity (Short position) = – £1,000,000 ($1.7600/£ – $1.7540/£ ) Value at maturity (Short position) = – $6,000 The loss on futures would reduce the value of receivable Value of receivable = £1,000,000 $1.7600/£ = $1,760,000 The net value of receivable is: $1,760,000 – $6,000 = $1,754,000 Implied exchange rate of conversion is $1,754,000 / £1,000,000 = $1.7540/£ (Rate at which we sold futures contracts.
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Trident’s Transaction Exposure Option market hedge Trident could also cover the £1,000,000 exposure by purchasing a put option. This provides the upside potential for appreciation of the pound while limiting the downside risk Given the quote earlier, a 3-month put option can be purchased with a strike price of $1.75/£ and a premium of $0.0265/£ The cost of this option would be $26,460 $0.0265/£ x £1,000,000 option of cost (premium) x option) of (Size = =
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Tride nt’s Transaction Exposure Because we are using future value to compare the various hedging alternatives, we need future value of the option cost in 3 months Using a cost of capital of 12% p.a. or 3.0% per quarter, the premium cost of the option as of June would be $26,460 1.03 = $27,254 or $27,254 / £1,000,000 = $0.0273/£ Since the upside potential is unlimited, Trident would not exercise its option at any rate above $1.75/£ and would convert pounds to dollars at
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