Amazon is completing construction on a new mega-warehouse outside of London, Eng

Question

Amazon is completing construction on a new mega-warehouse outside of London, England. The final construction payment is due in three months in the amount of 525,000. The current spot rate is 1.6500 $/, and the bid-ask quotes for the three month forward rate are 1.6600-1.6800 $/. If Amazon hedges in the forward market, what will be its dollar cost for the construction payment three months from now? Be specific about how they would hedge? ("Buy (Sell) dollars (pounds) forward")? Amazon may also choose to hedge using an option. The rates available on options to buy and sell pounds are as follows: Type of Option Strike Price Premium Cost Three month call on $ 1.65/$0.040/Three month put on $ 1,65/$0.030/Which option should Amazon consider? Why? Suppose Amazon chose to buy the option. Three months have passed and the spot exchange rate is now 1 58$/. What is the hedged dollar value of the payment? What is the hedged dollar value of the payment if the exchange rate is now 1.68$/? Suppose you are given prevailing interest rates in the US and UK, how would you structure a money market hedge (i.e. resorting to borrowing/lending)?

Explanation / Answer

(a) Construction payment is due in 3 months £ 525,000 Buying is done at the higher of rate as seller would like to earn more. The forward rate 1.6800$/£ Thus, dollar cost in construction payment = 525000 x 1.68 = $ 882,000 Thus, cost is $ 882,000 b) Amazon should go for call option as rule in the hedging: If Investor is, Then go for, (a) Long Short (sell) (b) Short Long (buy) Under this case, since investor does not have any pound,i.e., short . So, should for long (buy) in the option. Thus, Should go for call option c) Strike under call option 1.65 Spot exchange rate 1.58 It is better to abandoned the option and buy in spot market. Construction payment is due in 3 months £        525,000 Dollar cost in spot market 525000 x 1.58 = 829500 Add: premium cost 525000 x 0.04 = 21000 Total dollar cost $        850,500 Strike under call option 1.65 Spot exchange rate 1.68 It is better to exercise the option. Construction payment is due in 3 months £        525,000 Dollar cost in option market 525000 x 1.65 = 866250 Add: premium cost 525000 x 0.04 = 21000 Total dollar cost $ 887,250

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