Individual Project: Wainwright Plastics
Report format: MS Word
Delivery format: Turnitin
Report Style: Business report
It is March 20, 2018. You work as an analyst for Wainwright Plastics in Bedford Falls, Massachusetts. Sam Wainwright, the CEO, has ordered industrial plastic extrusion equipment from Great Britain at a cost of £ 35,250,000.
The payment of £ 35,250,000 is due in in pounds sterling, one year from now, on March 22, 2019. Sam Wainwright is concerned about the foreign exchange exposure of this upcoming payment. Especially during the last 12 months, currency market volatility has been high. The increase in volatility has been fueled mostly by concerns about Brexit.
State Street Bank in Boston offers the following spot rate and 12 months forward points1:
Spot ($/£) 1.3960 – 1.3965 12 months ($/£) 234 – 238 (.0234 / .0238)
You look at Bloomberg for interest rates to calculate a money market forward alternative:
USD LIBOR 12-months 2.56 % – 2.60 % GBP LIBOR 12-months 0.91 % – 0.96 %
You call the Bank of New York Mellon (BNYM) and ask for one year 1.42 $/£ strike call option to buy £ 35,250,000. BNYM quotes the following one year offer price for you to buy the option.
One year call option on Euro (exercise price) 1.4200 $/£ Percentage of $ amount at exercise price 4.60 %
Assignment: Analyze each of the alternatives below, and then choose one as your suggested hedging strategy. (Assume a 365 day year for all calculations.) The possible hedging choices are:
a) Remain unhedged.
Evaluate the risks and results of this strategy ($ cost) if the $/£ turns out to be 1.25, 1.30, 1.35, 1.40, 1.45, 1.50, 1.55.
b) State Street forward hedge. Explain the implementation of this hedge and the cash flows at maturity. What is the exchange rate that Wainwright would have to pay if they used this alternative?
c) Money market hedge. Explain the implementation of this hedge and the cash flows at spot and at maturity. What is the effective exchange rate that Wainwright would have to pay if they used this alternative?
1Forward quote conventions follow internationally accepted format. In the interbank market, dealers quote forward points as pips (1 pip is equal to 0.0001). To derive the outright forward rate, you need to add or subtract the appropriate forward points to or from the spot rate. If the forward bid points < forward ask points (forward premium), add the forward points to the spot. If the forward bid points > forward ask points (forward discount), subtract the forward points from the spot.
WAINWRIGHT
PLASTICS
d) BNYM option hedge.
i. Use the Black-Scholes model to see the implied volatility of the BNYM option premium using only the data in the case. In other words, what combinations of the given strike price, maturity, volatility, spot, and the USD LIBOR/Sterling LIBOR rates would generate the call option price. Include a screenshot of the option model.
ii. Evaluate historical volatility over 3 months and 1 year, using actual spot $/£ prices (not from the case) over the past three months and past year.
http://www.investopedia.com/ask/answers/021015/how-can-you-calculate-volatility-excel.asp
(Include screenshots of your final calculations – not all the data.)
iii. Look online/Bloomberg for current actual quotations of one year $/£ implied volatility. (Include screenshots.)
iv. Based upon what you found out about actual volatility (above in ii and iii), compare it to the implied volatility you found (above in i) to see if the BNYM call option is fairly priced.
v. Evaluate the overall hedged results of this strategy ($ cost) if the $/£ turns out to be 1.25, 1.30, 1.35, 1.40, 1.45, 1.50, 1.55 noting in what cases the option is exercised or not, and which exchange rate scenario of the above works out best for Wainwright if they hedged with the option.
Other hedging possibilities to include in your analysis
e) Currency futures hedge. Assume there is a currency futures market for the sterling that is fairly priced. Explain in detail the implementation of this hedge and the cash flows / transactions you would have to make on day one and at the time of the account payable if you were to use a futures hedge. (How many contracts would you buy or sell, when would you remove the hedge, etc.)
f) Synthetic option hedge. A synthetic option is where Wainwright can buy the delta-equivalent of the above option strategy, and adjust this position given future price movements. To execute on this strategy, what initial position would Wainwright take? Under what circumstances might this be preferable to the actual option strategy?
Deliverable: The deliverable should be formatted as if you work in the corporate finance department at Wainwright and are submitting this to the CEO. Please use only your own words. The following section headings are suggested:
Introduction of the problem
Analysis of each hedging alternative with valuations and risks/rewards
Recommendation
The case is due, for all sections, on Sunday, April 1st at 11pm via TURNITIN as a single MSWord document with all charts/graphs/pictures embedded into the document. You are strongly advised to start work on this soon, as it is a very complex case. Use the option model I post on Blackboard (under Course Documents / Wainwright) for all option calculations. Bloomberg is an excellent source for the data you will need.
I will give very clear guidance on how to do this case during class: M/W classes on Monday March 19th, and T/F classes on Tuesday March 20th. Be sure you attend one of these sections, as I will not re-explain the case during office hours. Out of fairness to all students, I will only answer additional questions on the case during class hours, so that everyone has the benefit of anything additional I say. Keep this in mind, as if you wait to start the case until the final weekend, you will not have the opportunity to ask any questions.
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