Dozier Industries

1502 Words Mar 25th, 2011 7 Pages
Dozier Industries

Rupinder Kaur
[Pick the date]

Dozier Industries was a U.S. manufacturer of electronic security systems. In 1986, it received a large order from the United Kingdom, which stipulated payment in British pounds. The company received a deposit, with the balance expected to be paid in 90 days. The contract provided a slim profit margin, which could be easily eliminated by an unfavorable change in exchange rates. The chief financial officer had to decide whether to accept the foreign exchange risk or to hedge the exposure.

i) Given that Dozier industries does nothing to hedge this risk, assuming that spot exchange rate remains the same as on Jan 14,1986 levels,
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By doing this, Dosier would incur an obligation to deliver pounds 90 days from now at the rate established today.
The contract would obligate Dozier Industries to pay £1,057,500 in exchange for
£1,057,500 x 1.4198 $/£ = $1,501,438.50

Assuming the transaction was at the quoted 3-month forward rate.
Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50

Dozier would accepting a reduction in the revenue from the contract of
$1,519,627.50 - $1,501,438.50 = $18,198.00 or
$18,198 / $1,519,627.50 = 1.20%

Cost of forward hedge = (Forward – Spot) / Spot
= (1.4198 – 1.4370) / 1.4370
= –0.0120 or –1.20 %

Since, the number is negative it shows that this is a "cost". If the result is positive, you are "benefiting" from the hedge relative to the value of the contract at current spot exchange rate.
There are no profits to account for in this type of hedging.

Hedging risk using a spot contract, works similarly in that it also creates a pound obligation 90 days hence. Dozier would borrow pounds and exchange the proceeds into dollars at the spot rate.
Give the interest rate is 1 and a half times that of prime lending rate,
At an interest rate of 15% per year (3.75% for three months, the amount to borrow equals
£1,057,500 / (1.0375) = £1,019,277.11

Dozier would immediately exchange the pounds into dollars at the current exchange rate. So…

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