Dozier Industries Case a
Dozier Industries has entered into an international sales transaction. As part of this contract, Dozier will be installing an internal security system for a manufacturing firm in UK, for which Dozier has already received 10% down payment and it is expected to receive another GBP 1,175,000. 00 in 3 months. Dozier’s costs are in USD, however its sales payment will be in GBP. Dozier is facing an exchange rate risk, especially since GBP has already depreciated by 2. 3% between the time sales bid( in GBP) was prepared and today( Jan 14th, 1986).
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Dozier has following options to cover its exchange rate risk: Do Nothing Dozier can adopt wait and watch policy and hope that GBP does not depreciate any further. In this Option, Dozier continues to face exchange rate risk. If the GBP depreciates further by 2. 71% from today’s level, Dozier’s profit would be completely wiped out. On the other hand, if GBP appreciate from today’s levels, then Dozier stands to gain from the upside on the currency exposure. Spot Hedge
In this option, Dozier can borrow funds in GBP, and convert them into USD at today’s spot rate. On April 13th, it will receive the payment from sales which it can use to pay off the borrowed fund in GBP. This option removes the uncertainty on the exchange rate. To implement this option, Dozier can follow these steps: 1. Borrow ? 1,019,277. 11 and use todays spot to convert it into USD. 2. Deposit the USD at 8% prevailing rate in US. I assume the initial down payment has already been converted to USD and deposited at 8% rate. . Receive the sales payment which equals the loan payoff amount. Payoff the loan. In this option, Dozier will still end up with 1. 43% on its cost. Forward Contract In this option, Dozier can buy a 3 months forward contract to sell GBP on April 13th. 3 months forward rates are known today and hence Dozier can eliminate its exchange rate risk. To implement this option, Dozier just needs these simple steps: 1. Enter into a 3 months forward contract to sell ? 1,057,500. 00 at the prevailing forward rate of 1. 198USD/GBP. 2. Use the sales payment of ? 1,057,500. 00 received on April 13th to settle the contract and received USD. This option will result in a net profit of 1. 88% for Dozier. I am assuming that the initial down payment has been converted into USD at today’s spot rate and that amount is deposited earning 8%APR interest in next 3 months. Also, I assume that the given forward rate covers all transaction costs. Therefore, I recommend the forward contract to hedge exchange rate risk. Appendix: Calculations