75 and would convert pounds to dollars at the spot

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option at any rate above $1.75/£ and would convert pounds to dollars at the spot market If the spot rate is $1.76/£, Trident would exchange pounds on the spot market to receive £1,000,000 $1.76/£ = $1,760,000 less the premium of the option ($27,254) netting $1,732,746 If the pound depreciates below $1.75/£, Trident would exercise the put option and exchange £1,000,000 at $1.75/£ receiving $1,750,000 less the premium of the option netting $1,722,746
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Trident’s Transaction Exposure As with the forward and money market hedges, a breakeven price on the option can be calculated The upper bound of the range is determined by comparison of the forward rate The pound must appreciate above $1.754/£ forward rate plus the cost of the option, $0.0273/£, to $1.7813/£ The lower bound of the range is determined by comparison to the strike price If the pound depreciates below $1.75/£, the net proceeds would be $1.75/£ less the cost of $0.0273/£ or $1.722/£ Note that the following graph shows the net proceeds of the option contract under varying exchange rates. Net proceeds are not same of a put option payoff diagram because we have exposure to the underlying asset (£)
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Trident’s Transaction Exposure Put Option Strike Price ATM Option $1.75/£ Option cost (future cost) $27,254 Proceeds if exercised $1,750,000 Minimum net proceeds $1,722,746 Maximum net proceeds unlimited Breakeven spot rate (upside) $1.7813/£ Breakeven spot rate (downside) $1.7221/£
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Cell E5 Entry is =IF(A5<$C$2,($C$2-$C$3)*$C$1,(A5-$C$3)*$C$1) N e t P r o c e e d s o f A l t e r n a t i v e s 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 A B C D E Exposure £1,000,000 Put Exercise 1.75 Put Premium 0.0273 (FV) Spot Rate Unhedged MM Forward Put Option 1.68 $1,680,000 $1,772,605 $1,754,000 $1,722,746 1.69 $1,690,000 $1,772,605 $1,754,000 $1,722,746 1.70 $1,700,000 $1,772,605 $1,754,000 $1,722,746 1.71 $1,710,000 $1,772,605 $1,754,000 $1,722,746 1.72 $1,720,000 $1,772,605 $1,754,000 $1,722,746 1.73 $1,730,000 $1,772,605 $1,754,000 $1,722,746 1.74 $1,740,000 $1,772,605 $1,754,000 $1,722,746 1.75 $1,750,000 $1,772,605 $1,754,000 $1,722,746 1.76 $1,760,000 $1,772,605 $1,754,000 $1,732,746 1.77 $1,770,000 $1,772,605 $1,754,000 $1,742,746 1.78 $1,780,000 $1,772,605 $1,754,000 $1,752,746 1.79 $1,790,000 $1,772,605 $1,754,000 $1,762,746 1.80 $1,800,000 $1,772,605 $1,754,000 $1,772,746 1.81 $1,810,000 $1,772,605 $1,754,000 $1,782,746 1.82 $1,820,000 $1,772,605 $1,754,000 $1,792,746 1.83 $1,830,000 $1,772,605 $1,754,000 $1,802,746 1.84 $1,840,000 $1,772,605 $1,754,000 $1,812,746 1.85 $1,850,000 $1,772,605 $1,754,000 $1,822,746 1.86 $1,860,000 $1,772,605 $1,754,000 $1,832,746 1.87 $1,870,000 $1,772,605 $1,754,000 $1,842,746 1.88 $1,880,000 $1,772,605 $1,754,000 $1,852,746 1.89 $1,890,000 $1,772,605 $1,754,000 $1,862,746 1.90 $1,900,000 $1,772,605 $1,754,000 $1,872,746
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Net Proceeds of Alternatives Hedging Alternatives $1,660,000 $1,680,000 $1,700,000 $1,720,000 $1,740,000 $1,760,000 $1,780,000 $1,800,000 $1,820,000 $1,840,000 $1,860,000 $1,880,000 $1,900,000 $1,920,000 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75 1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85 1.86 1.87 1.88 1.89 1.90 Exchange Rate ($/£) Net Proceeds Unhedged MM Forward Put Option
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Strategy Choice and Outcome Trident, like all firms, must decide on a strategy to undertake before the exchange rate changes but how a choice can be made among the strategies? Two criteria can be utilized: Risk tolerance - of the firm,as expressed in its stated policies and Viewpoint managers’ view on the expected direction and distance of the exchange rate Trident now needs to compare the alternatives and their outcomes in order to choose a strategy There were four alternatives available to manage this account receivable
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Strategy Choice and Outcome Hedging Strategy Outcome/Payout Remain uncovered Unknown Forward Contract hedge @ $1.754/£ $1,754,000 Money market hedge @ 8% p.a. $1,755,396 Money market hedge @ 12% p.a. $1,772,605 Put option hedge @ strike $1.75/£ Minimum if exercised $1,722,746 Maximum if not exercised Unlimited
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Managing an Account Payable The choices are the same for managing a payable Assume that the £1,000,000 was an account payable in 90 days Remain unhedged – Trident could wait the 90 days and at that time exchange dollars for pounds to pay the obligation If the spot rate is $1.7600/£ then Trident would pay $1,760,000 but this amount is not certain
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