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Foreign exchange risk management (2) Part 2 – ACCA (AFM) lectures

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  2. Hi John , i had used this method for the qn frongoch but however i wasnt able to get the answer , The qn : Today’s date is 1 March. Frongoch Co’s treasury team is currently looking at hedging a payment of €18,250,000 to a German supplier, which Frongoch Co is due to make on 1 August.
    Exchange rates (quoted as US$ per €1)
    Spot as at 1 March 1.1483–1.1497
    Five months forward 1.1528–1.1544
    Currency options (contract size €125,000, exercise price quoted as US$ per €1,
    Exercise price March June September March June September
    1.1540 0.54 0.61 0.69 0.79 0.90 1.02

    Could you please assist in this question

  3. Hi John
    Thanks for creating this series.

    I’ve been struggling with understanding choosing call or put when it comes to options. You mentioned that call is the right to buy the currency of the table given in the question. Let assume that the question gives us this heading for the table :Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1).

    And we are to receive CHF 12.3m of a future date. Is it a call or put option (the solution says it’s a put). Please explain the logic behind it. Thank you 🙂

    • We look at the currency that the contract size is quoted in (which in this case is CHF).

      If the transaction involves buying that currency (CHF) then we want a call (i.e. buy) option, whereas if the transaction involves selling that currency (as is the case here) then we want a put (i.e. sell) option.

  4. Hello sir,
    In Example 3
    When we calculate premium i.e $8250
    Its needs to be change in pound therfore we sell $ to buy pound
    And according to your rule when first currency sold we will use higher rate.
    So why are you using lower rate and also saying we need to buy $.

  6. great lecture! so currency swap can be arrange between the party involve or by using bank as intermediary if the transaction date is certainly known. But swaption is for when we are not sure when the exact date they want to borrow the money right?

    Thank you so much in advanced! 🙂

  7. Dear John,
    I am very thankful for your lectures!
    I have one small question that refers to example 3, section b). A company has the option to convert pounds into dollars at fixed rate. It’s a definition of an option. Then why they should receive the difference between option and spot rate instead of dollars? Or this is a typical bank transaction and company cannot insist on the other way of exercising the option?

    From my point of view it would be easier just to receive the amount in dollars from bank and pay it to supplier. Although it would little bit cheaper as we are not translate the amount from pounds to dollars twice. The difference is about 31 pound for this example.

    Thank you in advance

  8. Sir in your previous video lecture you mentioned that each of these months(depicting month ends), give us an opportunity to buy options. So i was just thinking that if we have to pay $1m IN/DURING April then why will buy PUT options in the end of april? instead should not we be buying PUT options in the march end?

    Thanks in advance!

  12. Hello Professor,

    I was trying to post this in Ask The Tutor section but keep on getting message that the page does not exist.

    My question does not relate to the above lecture but to the question from December 2018 – Nutourne Co.

    When hedging the exchange rate risk using options in the answer book the Put Option was selected. I do not understand why put option.

    The company is expecting the receipt of CHF 12,300,000 so when it happens it will have to sell CHF and Buy $ – therefore call option should be selected.

    Please help me understand the reasoning for selecting the put option.

    Thank you for your help in advance.

    • They will indeed be selling CHF, and since the contract size is quoted in CHF they will buy options to sell CHF, i.e put options. I do explain this in the lectures.

      (And the Ask the Tutor is working fine – I don’t know where you tried, but you should have chosen ‘forums’ at the top of this page, and then selected the ‘Ask the Tutor AFM forum’)

    • Hello Professor,

      So if the contract size is quoted in the currency that we are going to make the payment for it is always going to be a put option? Otherwise sell option is it correct?

      Thank you

      • If you are paying money in (say) CHF’s and the contract size is quoted in CHF’s then because you will need to buy CHF’s in order to make the payment, you will buy a call option (which is the right to buy CHF’s at a fixed rate).

        If you are receiving money in (say) CHF’s and the contract size is quoted in CHF’s, then because you will need to sell the CHF’s that you receive (to convert into your own currency) then you will buy a put option (which is the right to sell CHF’s at a fixed date).

        You will not be selling options – you are always buying options!

  13. Hi Sir

    You have a great teacher. I pick up lot of points from your lecture. Its a blessing.

    Although, this is not the right forum, since, ask the teacher is not working. I have to bother you here.

    Can you please illustrate or provide me any source from which I can see illustration of “Closing out when traded options still have time to run”

    Regards
    Thanks in Advance

    • The Ask the Tutor Forum is working fine 🙂

      Traded options cannot be exercised before the due date unless they are American style options (as I explain the lecture). However although European options cannot be exercised sooner, they can be sold on the exchange which would effectively have the same effect (but you are not expected to do this in the exam).

  14. hi in part b when we are converting the excess receipt amount from dollar to pound why we are using 1.4120 because bop kits 1.4100 is used instead…please clear.

  15. Hi John,

    Thank you for the wonderful lectures. I still have a query though. I would be very thankful if you could shed some light on this one.

    “A US co. owes 600000 Euro to a Spanish co. on 15 may on 3 months credit. Strike rate is(Euro 0.7700= $1), Contract size is Euro 10000 options. If Spot rate in August is 0.7500 what is the dollar cost ?”

    The above question is from BPP text book. I calculated Premium at $ 21420 and that was correct. However when I tried calculating the Net outcome, I tried solving the way you mentioned and hence
    *I converted the transaction at spot (600000/0.75 = $800000 ) [pay]
    *Gain on Option
    600000 euro (0.7700- 0.7500) = 12000 eu/0 .75 = $16000 [reciept]
    *Premium = $21420 [Pay]
    **NET OUTCOME = $805420 [Pay]

    However as per the text book Net outcome was $800641. It simply Calculated

    *Options postion (600000/0.77) = $779221
    *premium = $21420

    I am very confused. Where did I go wrong ? why wasnt the gain on hedge calculated in the text book.? Could you please clarify ?

    Thanks in advance.

    • In future please ask this kind of question in the Ask the Tutor Forum and not as a comment on a lectures.

      If they are traded options, then strictly it should be done the way I do it in the lectures because that is how they work in practice. If you did it the other way you would probably still get the marks because the net effect is the same (the difference is due to roundings and that is irrelevant in the exam).

      If they are over the counter (OTC) options, then if the option is exercised then the conversion takes place at the option rate as BPP have done.

      • Thank you very much. I am sorry about the elaborated question. I”ll keep that in mind in future.

        However, I Just wanted to know if my calculation is correct ? Can the roundings create a difference of around $5000 ?

        Thank you once again.

    • The effect of options is to give the right to convert at the strike rate if it is better than converting at whatever the spot rate is. However the way that traded options actually work is that the transaction is converted at spot, and if the option rate is better then the difference is ‘claimed back’ from the dealer.

  17. Hi John,
    The lectures are brilliant thank you. Just one question on this one, in part a once we have the premium in $ and convert to £, why do you use 1.4850 rate which is the buy $ price rather than the 1.4870 which is the sell $?
    Thank you for your help
    Kathryn

  18. The option is the right to convert Pounds to $’s, but the price charged for having the option can be quoted in any currency. Here they are charging 1.20 cents for every GBP that you want the option on.
    You will always be told in the exam what currency the premium is charged in (at the top of the table of premiums).

  19. Dear John,

    very helpful lecture indeed!

    one bit bothers me in question 3:

    22 contracts x 31250 (contract size in pounds) x 1.20 cents = $ 8250

    Could you explain how can the contract amount in £31250 when multiplied with the premium in cents yield a figure in USD $?

    i know this is small bit i am not able to get my get around, but i see the 1.20 as premium on exchange rate and not the “complete exchange rate” itself to convert to USD from GBP

    many thanks

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