It is from past paper of dec 2012

This is past question of P4 of tuesday 4 december 2012
Lignum Co, a large listed company, manufactures agricultural machines and equipment for different markets around the world. Although its main manufacturing base is in France and it uses the Euro (€) as its base currency, it also has a few subsidiary companies around the world. Lignum Co’s treasury division is considering how to approach the following three cases of foreign exchange exposure that it faces.
Case One
Lignum Co regularly trades with companies based in Zuhait, a small country in South America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to deliver to a company based there. It is expecting full payment for the machinery in four months. Although there are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-counter derivative products.
The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 8·5% plus 25 basis points and the French base rate of 2·2% less 30 basis points.
Alternatively, with the second derivative product Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the current spot exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call option or ZP5 per €1 for the put option.
The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money at the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France.
Case Two
Namel Co is Lignum Co’s subsidiary company based in Maram, a small country in Asia, whose currency is the Maram Ringit (MR). The current pegged exchange rate between the Maram Ringit and the Euro is MR35 per €1. Due to economic difficulties in Maram over the last couple of years, it is very likely that the Maram Ringit will devalue by 20% imminently. Namel Co is concerned about the impact of the devaluation on its Statement of Financial Position.
Given below is an extract from the current Statement of Financial Position of Namel Co.
MR ’000 Non-current assets 179,574 Current assets 146,622 –––––––– Total assets 326,196 ––––––––
Share capital and reserves 102,788 Non-current liabilities 132,237 Current liabilities 91,171 –––––––– Total capital and liabilities 326,196 ––––––––
The current assets consist of inventories, receivables and cash. Receivables account for 40% of the current assets. All the receivables relate to sales made to Lignum Co in Euro. About 70% of the current liabilities consist of payables relating to raw material inventory purchased from Lignum Co and payable in Euro. 80% of the non-current liabilities consist of a Euro loan and the balance are borrowings sourced from financial institutions in Maram.
Case Three
Lignum Co manufactures a range of farming vehicles in France which it sells within the European Union to countries which use the Euro. Over the previous few years, it has found that its sales revenue from these products has been declining and the sales director is of the opinion that this is entirely due to the strength of the Euro. Lignum Co’s biggest competitor in these products is based in the USA and US$ rate has changed from almost parity with the Euro three years ago, to the current value of US$1·47 for €1. The agreed opinion is that the US$ will probably continue to depreciate against the Euro, but possibly at a slower rate, for the foreseeable future.
4
Required:
Prepare a report for Lignum Co’s treasury division that:
(i) Briefly explains the type of currency exposure Lignum Co faces for each of the above cases; (3 marks)
(ii) Recommends which of the two derivative products Lignum Co should use to manage its exposure in case one and advises on alternative hedging strategies that could be used. Show all relevant calculations; (9 marks)
(iii) Computes the gain or loss on Namel Co’s Statement of Financial Position, due to the devaluation of the Maram Ringit in case two, and discusses whether and how this exposure should be managed; (8 marks)
(iv) Discusses how the exposure in case three can be managed. (3 marks)
Professional marks will be awarded in question 2 for the structure and presentation of the report. (4 marks)
(27 marks)
ans is

Appendix I: Financial impact of derivative products offered by Medes Bank (case one)
Using forward rate Forward rate = 142 x (1 + (0·085 + 0·0025)/3)/(1 + (0·022 – 0·0030)/3) = 145·23 Income in Euro fixed at ZP145·23 = ZP140,000,000/145·23 = €963,988
Using OTC options Purchase call options to cover for the ZP rate depreciating Gross income from option = ZP140,000,000/142 = €985,915
Cost €985,915 x ZP7 = ZP6,901,405 In € = ZP6,901,405/142 = €48,601 €48,601 x (1 + 0·037/3) = €49,200 (Use borrowing rate on the assumption that extra funds to pay costs need to borrowed initially; investing rate can be used if that is the stated preference)
Net income = €985,915 – €49,200 = €936,715
I need to know only why call option is purchased since we have to sell ZP to get €,and we must have either call option in € or put option on Zp,but as contract size is not given here ,how can we know which to have call and put option