# 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.
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
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
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
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.
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 = =
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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