Tile Hill Tyres Ltd is a UK company. It is expecting to receive payments of $5 million in three months' time. The current spot rate is $1.38/E. The company is considering three alternatives: 1) Hedge the receipt using a 3-month forward contract at the rate of $1.35/E 2) Hedge the receipt by using an OTC option from the bank, giving Tile Hill Tyres Ltd the option to sell $ at a strike price of $1.36/f for a premium of 1.2p per $ 3) Do nothing Required: a) In each case, compare the results if in three months' time the exchange rate has moved to a. $1.32/E b. $1.44/E and comment on the results (60 Marks) b) Calculate the exchange rate at which it would be beneficial to use the option rather than the forward. (15 Marks) c) Critically appraise the use of currency options to manage exchange rate risk. (25 Marks) (Total 100 Marks)

Explanation given below

Refrence:

https://docs.google.com/spreadsheets/d/1PvJ_asjiwcdKeDiO18GQWXjDiYeRaN0Df5MUzTkb7Vg/edit?usp=sharing

Step-by-step explanation

(a)

Calculation using forward market hedge:

STEP 1:

Total invoice $5 million Current spot rate 1.38 / pound Three month forward rate 1.35 pound

STEP 2:

Spot rate at the end of 3-months Scenario 1:
1.32 /pound Scenario 2: 1.44 /pound

STEP 3:

Due to anticipation of volatility in the market, the UK company decided to buy USD 5 m at 3-month forward rate So, the amount they get = 5000000/1.35 = 3703704 pound =5000000/1.35

STEP 4:

Had they not exercised the forward contract, at the end of 3 months, they would have received
money based on 3-month spot rate Scenario 1: 5000000/1.32 3787879 LOSS = -84175 (3703704
- 3787879) Scenario 2: 5000000/1.44 = 3472222 Gain= 231481 (3703704 - 3472222)

In case of forward market hedge, 

Scenario 1: When the UK company decides to receive $5 million at a 3-month forward rate of $1.35/pound, the company will incur a loss.

Scenario 2:When the UK company decides to receive $5 million at a 3-month forward rate of $1.35/pound, the company will incur a profit.

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(b)

Calculation using OTC option

STEP 1:

Athree-month option is available for $5m with a strike price of $1.36!! fora premium payable now of
1.2p per $ on the over-the—counter market So, total premium paid for$5 million 2 _pounds 6.012
*S??????

STEP 2:

So, in 3 months time, the UK company has the option to exercise the put option at a strike price of
$1.36/f

Spot rate at the end of 3—month5 Scenario 1: 5 II"p~ounr:i So, we do not exercise the put
option. So, 35 million is. exchanged at 3— months spot rate SMILE = 3?8?3?8.?9

STEP 3:

Scenario 2: 1.44 /pound So, we exercise the put option So, $5 million is exchanged at strike price
of $1.36/E 5000000/1.36 3676470.59

Based on the calculation using OTC option,

we exercise the put option @ $1.36/pound.

However, if we compare the 2 scenarios with the forward market rate,  3-month spot rate of $1.32/pound can be opted as it converst maximum return for the UK firm.

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(c) When the company does not opt for any hedging option

Total Invoice = $5 million

Amount received in pounds =