On January 13, 1986 Dozier Industries, an American based firm, received notice that a bid on a project in the United Kingdom had been accepted. The project was to bring in £1,175,000 in revenue. Therefore, the revenue received for this project will need to be transferred into US dollars. When Dozier issued the bid on December 3, 1985 the project the exchange rate was $1.4820/£. This rate would have provided Dozier with the desired 6% profit on the project. On January 13, the day the bid was accepted, the exchange rate had changed to $1.4480/£. On January 14 the rate had change again to $1.4370/£. This inflation in the dollar to the British pound has severe implications for the profit potential on this …show more content…
These options contracts have a total premium of $11,025. In order to break even on this contract the British pound would need to depreciate to a level of $ 1.4395/£.
(Please refer to Figure 2, attached)
By entering into option contract number three on December 3 (since the January spot rate is known) Dozier would have realized a profit of $281.25 by selling the nine options they could have bought to insure the value of the deposit they knew they could receive in January. An alternative to this would be to actually execute the currency trade guaranteed by the option with the British pounds received as the deposit.
On December 3, 1985 current exchange rate trends suggested that the British pound could continue to appreciate against the dollar (the overall trend for the preceding five months). This is perhaps why Dozier did not consider hedging for exchange rate risk. If they had acknowledged the currency risk and bought the options, they would have been in the money by a significant amount according to the January spot rate. However, at the time this degree of hedging seemed largely unnecessary.
Dozier’s bid preparation in this case was negligent. Using the spot rate December 3, 1985 after five months of an overall trend of British pound appreciation was irresponsible and could have been avoided.