dozier case study

UVA-F-0746

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 meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

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 companys 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).

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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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Exhibit 1


Historical Spot and Forward Pound Rates in U.S. Dollars

3-month Date Spot Forward Rate

7/9/85 1.3640 1.3490 7/16 1.3880 1.3744

7/23 1.4090 1.3963 7/30 1.4170 1.4067 8/6 1.3405 1.3296 8/13 1.3940 1.3828 8/20 1.3900 1.3784 8/27 1.3940 1.3817 9/4 1.3665 1.3553 9/10 1.3065 1.2960 9/17 1.3330 1.3226 9/24 1.4200 1.4089 10/1 1.4120 1.4005 10/8 1.4155 1.4039 10/15 1.4120 1.4007 10/22 1.4290 1.4171 10/29 1.4390 1.4270 11/5 1.4315 1.4194 11/12 1.4158 1.4037 11/19 1.4320 1.4200 11/26 1.4750 1.4628 12/3 1.4820 1.4704 12/10 1.4338 1.4214 12/17 1.4380 1.4249 12/23 1.4245 1.4114 12/30 1.4390 1.4260 1/7/86 1.4420 1.4284 1/14/86 1.4370 1.4198

Source: Chicago Mercantile Exchange Statistical Yearbook.

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Exhibit 2


Foreign Currency Options on January 14, 1986 Options & Strike Underlying Price Calls-Last Puts-Last

Jan. Feb. Mar. Jan. Feb. Mar. 12,500 British Pounds - cents per unit B Pound 130 s r 13.50 s r r 144.41 135 s r 9.20 s 0.20 0.50 144.41 140 s 4.50 4.75 s 0.80 1.55 144.41 145 s 1.55 2.50 s 3.10 4.40 144.41 150 s 0.40 0.90 s r r r - not traded s - no option offered Last is premium (purchase price). Source: Wall Street Journal. Foreign Currency Options listed on the Philadelphia Exchange.

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Exhibit 3


Foreign Currency Options on December 3, 1985 Options & Strike Underlying Price Calls-Last Puts-Last

Dec. Jan. Mar. Dec. Jan. Mar. 12,500 British Pounds - cents per unit B Pound 120 29.00 s 28.95 r s r 148.86 130 19.10 r r r r r 148.86 135 13.80 r 14.60 0.05 r r 148.86 140 8.80 r 10.00 0.05 r s 148.86 145 4.00 4.50 5.70 0.20 1.05 3.20 148.86 150 0.65 1.65 3.35 r r 5.60 148.86 155 r 0.50 1.70 r r r r - not traded s - no option offered Last is premium (purchase price). Source: Wall Street Journal. Foreign Currency Options listed on the Philadelphia Exchange.
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