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Hi tutor , there’s a currency option question named NTC from June 2002 paper and option cost is required in this question,
data is: payment in 3 months $278995
Spot ($/£) 1.4358_1.4366
3 months rate 1.4285_1.4300
Contract size £31250
Strike price 1.44
Premium 4.35
Option outcome is £199478
UK BORROWING RATE IS 6.9 % AND DEPOSIT RATE IS 6%
USA BORROWING RATE IS 6.2% AND DEPOSIT RATE IS 5.4%
If we incorporate borrowing rate in premium, option outcome is £199576
how to find option cost with this data
Please guide meYou do not say which part of the answer is causing you the problem (and I assume that you have watched the free lecture on options).
With a strike of 1.44, it needs 278995/1.44 / 31250 = 6 contracts.
Also, because we are buying $’s (therefore selling GBP’s) it is a put option that is required.So the premium payable is 6 x 31250 x 0.0435 = $8156.25. It is payable immediately, and so converting at the current spot gives 8156.25 / 1.4358 = GBP 5,681.
This is payable immediately, and so to make it comparable with the other methods (money market and forward) where the cash flow occurs in 3 months time, we need to add on 3 months interest. Borrowing GBP means interest of 6.9% p.a., so for three months it is 3/12 x 6.9% = 1.725%.
So the cost of the premium after 3 months is GBP 5681 x 1.0175 = GBP 5,780.
(Which is an extra GBP 99 which explains the difference between the final outcome of 199478 (which I assume you were happy with?) and the actual answer of 199576.)In question it is required to find out option cost and what should be the desired spot rate
Here is copy paste of solution by BPP, i didn’t understand this part of solutionPayment on money market £195017
Less:
Amount Hedged in forward
market £(6297)
Premium £(5779)
Required option cost = £182941Then,
Required spot rate=270000/182941
=1.4759
I didn’t understand this calculation, why are we doing this, It is written as a note that NTC wants to minimize transaction costI wish you had said this in your original question – it would have saved me a lot of time 🙂
The question does not ask for an option cost. What it actually asks is for you to include in your discussion an evaluation of under what circumstances currency options would be the preferred choice (i.e. better than money market hedging).
Options are preferable if the spot rate it below a certain level because with options you do not then need to exercise the option and you get the benefit of the lower exchange rate. With money markets the final amount is fixed and so although you will not suffer if exchange rates are higher, you do not benefit if exchange rates are lower (whereas with options you do).
With a strike of 1.44, then because of contract size it will be $270,000 that is being hedged using options (the workings for this are in workings (4)). If the options are exercised then the final outcome is a payment of GBP 182,941 (it is wrong really of them to call it an ‘option cost’) then it would only be exercised if the spot rate was above 270,000 /182,941.
Thanks loads , now i understood the requirement of the question
But I’m confused over this figure £195017 which is written as Payment in money market,
How did they get this figure or what rate they used?It comes from workings (2) and it is a bit naught of them because the have rounded slightly differently (from workings (4) is 195,032.
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