A U.S. exporter owes £3,500,000 in six months and is planning to use an option market hedge. The contract sized for options on the British Pound is £100,000. The strike price is X($/£)=1.51 for both calls and puts. The call premium is $0.05/£ while the put premium is $0.03/£. The spot rate next year is expected to be either S1($/£)=1.49 or S1($/£)=1.54 while the current spot rate is S0($/£)=1.51. The interest rate in the U.S. is i$=0.25%. Show how to implement an option market hedge. Show all the cash flows involved and the value of the payable at maturity after the option hedge.
A U.S. exporter owes £3,500,000 in six months and is planning to use an option market hedge. The contract sized for options on the British Pound is £100,000. The strike price is X($/£)=1.51 for both calls and puts. The call premium is $0.05/£ while the put premium is $0.03/£. The spot rate next year is expected to be either S1($/£)=1.49 or S1($/£)=1.54 while the current spot rate is S0($/£)=1.51. The interest rate in the U.S. is i$=0.25%. Show how to implement an option market hedge. Show all the cash flows involved and the value of the payable at maturity after the option hedge.
Related questions
Coleman needs 100,000 euros in 1 year, then it could convert dollars to euros and deposit the euros in a bank today.The Coleman purchasing team received this price quote of â¬100,000 today where the current spot rate was $1.1800/â¬, which equates to the U.S. dollar price of $118,000.
Coleman's director of finance now wondered if the firm should hedge against more fluctuation in the exchange rate.
Three approaches were possible:
1) Hedge in the forward market. The 1-year forward exchange quote was $1.20/â¬.
2) Hedge in the money market. Coleman could borrow U.S. dollars from its U.S. bank at 7.00% per annum. The EU investment rate is 9.00% per annum.
3) Hedge with foreign currency options. The day the Euros are needed the call options at $1.2000/⬠could be purchased for a premium of $0.03. (Note: First you need to figure out the option premium in percentage. The spreadsheet cell D32 is not set-up for USD)
Discuss if Coleman should hedge its transaction exposure of EUR 100,000. If you recommend that the company should hedge, which of the hedging alternatives would better serve Northwind shareholders?
| Assumptions | Value | |
| 1-year A/P in ⬠| ? | |
| Spot rate, ($/â¬) | ? | |
| 1-year forward rate, ($/â¬) | ? | |
| EU investment rate | ? | |
| borrowing rate, USD, per annum | ? | |
| Coleman's WACC | 10.000% | |
| Time to maturity (in months) | 12.00 | |
| Options on Euro: 1-year Strike price, ($/â¬) | Call Option | |
| Strike price ($/£) | ? | |
| Option premium ? Solve this using step by step calculations |
Looking at the following options table:
| British Pound Option Prices (U.S. CENTS per Pound, 62,500 pounds per contract) | ||||||||
| US cents/£ | Call | Call | Call | Put | Put | Put | ||
| Spot Rate | Strike Price | May | June | July | May | June | July | |
| 144.8 | 144 | 0.88 | 1.42 | 1.44 | 0.52 | 1.06 | ----- | |
| 144.8 | 145 | 0.42 | 1.02 | ----- | ----- | ----- | ----- | |
| 144.8 | 146 | 0.2 | 0.68 | 0.72 | 1.75 | 2.32 | ----- | |
| QUESTION A: | Give me one example of an option that is out of the money? Be specific as far as month and strike price. Explain your answer? | |||||||
| QUESTION B: | Give me one example of an option that is in the money? Be specific as far as month and strike price. Explain your answer? | |||||||
| QUESTION C: | Which, if any, option is at the money? Explain your answer. | |||||||
| QUESTION D: | Looking at the July 144 CALL option, break down the option's premium into its Intrinsic Value and Time Premium components | |||||||
| Show your calculations. | ||||||||
| QUESTION E: | Looking at the June 146 PUT option, break down the options premium into its Intrinsic Value and Time Premium components | |||||||
| Show your calculations. | ||||||||
| QUESTION F : | If you purchase two (2) June 145.0 call options what will be the total amount of your premium that you need to pay? | |||||||
| QUESTION G: | Referring to QUESTION F, when do you pay the option premium, on the settlement date or on the date that you purchase the options? | |||||||
| QUESTION H: | Today you purchase three (3) June 144.0 Puts. On settlement date the spot rate = 142.5 cents per pound, what is your net profit/loss? | |||||||
| Show your calculations. | ||||||||
| QUESTION H: | Today you purchase two (2) June 144.0 Calls. On settlement date the spot rate = 143.5 cents per pound, what is your net profit/loss? | |||||||
