•
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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- Fall '19
- Trident