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My question relates to the calculation of the options in part (a) of the Casasophia question from Jun 11.
The question asks for a recommendation for a hedging strategy. I take that as proposing the single best solution, so if an option is obviously inferior, we can recommend to ignore.
The forward rate is $1.3623/euro.
For the currency options, there are two exercise prices: 1.36 and 1.38.
My questions:
(1) Is it safe to assume that at the exercise price of 1.38, it is worse than the forward rate in any case so we can state our assumptions and not having to go through with the calculations?
(2) If my assumptions in (1) is incorrect: After calculating the option of the exercise price of 1.36, I found the effective exchange rate to be $1.3885/euro, which is higher than the forward rate. Can I now then assume that the effective rate for the option at 1.38 will be higher and therefore not worth calculating? I appreciate that option allows for flexibility though would just calculating the exercise price at 1.36 to demonstrate the point be sufficient?
The primary objective of my questions is to see whether I can conserve time.
Many thanks.
The question is asking for your advice, and so just as in real life there is no one solution that is guaranteed to be the best and I am afraid there is not ‘quick way’ here – you need to show the calculations (as in the requirement) and then suggest what is your advice. Given that this is a higher level exam, the marks are not for your recommendation itself but for the calculations and then a reasoned discussion as to which method you would advise (whichever you advised is irrelevant if your discussion is sensible).
The problem with what you have said about one of the exercise prices being higher than the forward rate is that we do not know what will actually happen to the spot rate. Using options limits the worst outcome, but if the spot rate moves in our favour then we can use the spot rate and ignore the option. However if we use forward rates then we have to use that rate whatever happens to the spot rate.
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