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UVA-F-0746 Dozier Industries (B)

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UVA-F-0746

DOZIER INDUSTRIES (B)

Richard Rothschild, the chief financial officer of Dozier Industries, was still contemplating how best to manage the exchange risk related to the company’s new sales contract. The £1,057,500 balance of the contract was due in three months on April 14, 1986, creating a long position in British pounds. Rothschild had spoken previously to John Gunn, an officer in the International Division of Southeastern National Bank, about hedging his long pound exposure. Gunn had explained two alternatives available to Dozier to reduce the exchange risk: a forward contract or a spot transaction. Either transaction would ensure that Dozier receive a set dollar value for its pound receivable, regardless of any change in the value of the pound. Given his previous analysis of the foreign exchange market, Rothschild was concerned that both of these hedging alternatives would lock in a profit margin below the 6% he had originally anticipated for the contract. He wondered if there were some way to get the upside potential without all the risk. The pound had weakened since his bid submission date on December 3 (see Exhibit 1), but he was not entirely convinced it would continue to fall, or at least not as much as the forward rate indicated. If the future spot rate were greater than the current forward rate, an unhedged position could lead to a gain, whereas a hedged position would create an opportunity lost. Rothschild wondered if other alternatives were available, and he again called John Gunn at the bank for advice. Gunn explained that Rothschild could also use currency options to hedge against his uncertain foreign exchange exposure. Options provide a means of hedging against volatility without taking a position on expected future rates. Gunn explained that there are two basic varieties of options contracts: “puts” and “calls.” A put gives the holder the right, but not the obligation, to sell foreign currency at a set exercise or “strike” price within a specified time period. A call gives the holder the right to buy foreign currency at a set price. In comparison with a forward or futures contract, the holder of an option does not have to transact at the agreed-upon price, but has the choice or option to do so. Gunn told Rothschild that options are complicated and increase the front end cost of hedging in comparison with a forward hedge. He said Rothschild could find the prevailing option contract prices in the Wall Street Journal (see Exhibit 2).

This case was prepared by Leslie Zanetti under the supervision of Professor Mark R. Eaker. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 1987 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. ◊

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UVA-F-0746

It appeared to Rothschild that options contracts might provide some benefit. He wondered if options contracts were the best alternative for Dozier right now. He also wondered whether he could have used options contracts when preparing his bid.

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UVA-F-0746

Exhibit 1 DOZIER INDUSTRIES (B) Historical Spot and Forward Pound Rates in U.S. Dollars

Date 7/9/85 7/16 7/23 7/30 8/6 8/13 8/20 8/27 9/4 9/10 9/17 9/24 10/1 10/8 10/15 10/22 10/29 11/5 11/12 11/19 11/26 12/3 12/10 12/17 12/23 12/30 1/7/86 1/14/86

Spot 1.3640 1.3880 1.4090 1.4170 1.3405 1.3940 1.3900 1.3940 1.3665 1.3065 1.3330 1.4200 1.4120 1.4155 1.4120 1.4290 1.4390 1.4315 1.4158 1.4320 1.4750 1.4820 1.4338 1.4380 1.4245 1.4390 1.4420 1.4370

Source: Chicago Mercantile Exchange Statistical Yearbook.

3-month Forward Rate 1.3490 1.3744 1.3963 1.4067 1.3296 1.3828 1.3784 1.3817 1.3553 1.2960 1.3226 1.4089 1.4005 1.4039 1.4007 1.4171 1.4270 1.4194 1.4037 1.4200 1.4628 1.4704 1.4214 1.4249 1.4114 1.4260 1.4284 1.4198

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UVA-F-0746

Exhibit 2 DOZIER INDUSTRIES (B) Foreign Currency Options on January 14, 1986

Options & Underlying

Strike Price

Calls-Last Jan.

12,500 British Pounds - cents per unit B Pound 130 144.41 135 144.41 140 144.41 145 144.41 150

s s s s s

Feb.

Puts-Last Mar.

r 13.50 r 9.20 4.50 4.75 1.55 2.50 0.40 0.90

r - not traded s - no option offered Last is premium (purchase price). Source: Wall Street Journal. Foreign Currency Options listed on the Philadelphia Exchange.

Jan.

s s s s s

Feb.

r 0.20 0.80 3.10 r

Mar.

r 0.50 1.55 4.40 r

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UVA-F-0746

Exhibit 3 DOZIER INDUSTRIES (B) Foreign Currency Options on December 3, 1985

Options & Underlying

Strike Price

Calls-Last Dec.

12,500 British Pounds - cents per unit B Pound 120 148.86 130 148.86 135 148.86 140 148.86 145 148.86 150 148.86 155

29.00 19.10 13.80 8.80 4.00 0.65 r

Jan.

s r r r 4.50 1.65 0.50

r - not traded s - no option offered Last is premium (purchase price). Source: Wall Street Journal. Foreign Currency Options listed on the Philadelphia Exchange.

Puts-Last Mar.

28.95 r 14.60 10.00 5.70 3.35 1.70

Dec.

r r 0.05 0.05 0.20 r r

Jan.

s r r r 1.05 r r

Mar.

r r r s 3.20 5.60 r