A US based IT firm required GBP 100000 in 180 days. The company feels that exchange rates are expected to fluctuate in the next 6 months. Their near accurate estimate based on a good quality research were as below:
Current Rate of GBP = USD 1.50
180 days forward rate for GBP = USD 1.48
Call premium USD 0.02 (strike price of USD 1.50 for 180 days)
Interest Rates in London for deposits – 4.5% and for loans – 5.1%
Interest Rates in New York for deposits – 4.5% and for loans – 5.1%
A fair estimate of exchange rate after 180 days is expected to be USD 1.44 with a probability of 20%, USD 1.46 with a probability of 60% and USD 1.53 with a probability of 20%.
Advise the company on a good hedging strategy. Make suitable assumptions if required and state the same.
Monetary markets .
They can use through options by buying a put/call option to enable security in case of any future fluctuations in the money markets this will enable minimize on loses or make profits in in future once it has reached maturity .
They can make use of the available interest rates calculated on principal by making deposits and lending out on loans and weigh in on probability .
assumption that they can make are that :
all factors will be kept constant and they will be no major market fluctuations.
Hedging will increases liquidity .
Hedging will provide a mean to mitigate market risk and volatility
Hedging might not prevent losses, but it can considerably reduce the effect of negative impacts.