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Explanation on comments made about currency options in comparison with other alternative hedging strategies.
The outcome of various hedging strategies for payment of $1,150,000 in five months are as follows:
Foward Contract; payment fixed at $1,150,000/1.9029=£604,341Futures hedge; Expected lock-in rate 1.9035
Currency Options; worst case scenarios – put options bought
. 1.88 1.90 1.92
B cost(£) 593,750 593,750 593,750
Prem($) 9,175. 13,452. 20,302
U h(@ fow17,736. 11,496. 5,255Total 620,661 618,698 619,307
Comments:
“If the dollar weakens relative to the pounds, the option allows the company to take advantage of any remaining time value. In this situation, the dollar would have to weaken to about $1.98/£ before the currency option became any more favourable than the forward contract or futures hedge.”1.92
But what is it that you are asking?
(Have you watched my free lectures on foreign exchange risk management?)
I dont understand the comment made, even though i understand the hedging strategies.
If the dollar weakens and the exchange rate goes above the exercise price of the option, then they won’t exercise the option and will convert at the actual rate instead.
However, the premium will still be payable and the under hedge will still be converted at the forward rate.
So to end up being better than using futures or using a forward contract the actual exchange rate will have to be enough higher than the exercise price to cover the cost of the premium.
I cannot tell you how the answer arrived at a rate of about 1.98 without seeing the whole question. You have not given the contract size, and also the totals you have given (620,661 etc.) are the totals of the 3 figures you have typed above, which does not make sense given that you have written that one is in Pounds and one is in Dollars.
The question is not in the BPP Revision Kit, but if it is a past exam question then tell me which exam and I will be able to find it. (I do not have the Kaplan kit if you found it there)
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