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      • P4 is testing that you understand the nature of options and how they work. On occasions you have been told the spot rate on the future date, in which case you can calculate the exact result. On other occasions (as in Casasophia) you are not given the spot rate and you are expected to show what the worst outcome would be (i.e. if the options were to be exercised) and what the relative costs are (i.e. the premiums) and then discuss/recommend. This is what the situation would be in real life when deciding whether or not to use options. Obviously in real life you would not know what the future spot rate would be at the time you were deciding whether or not to buy options.

        (In future please ask about specific questions in the Ask the Tutor Forum and not as a comment on a lecture.)

  2. hi john,
    im confused as to why we didnt just divide 100,000/strike price 1.475 and get 677966.10 and then add in the premium.

    why go the long way of converting at todays buy rate the first 100,000 element and then adding the differece of the profit or loss element.
    the former gave 677966.10 and the latter 677572.

    my ears inside is shouting at me that it is because of the element of the fixed size contract but we didnt get a perfect hedge did we cuz we rounded 21.69 to 22. does the examiner have a “relevent range” answer or the former solution is also correct?

  3. Hello Tutor,
    I observe you, unlike other solutions I’ve seen, were not bothered about rounding up the number of contracts as the division didn’t give a round figure.

    Isn’t it important and doesn’t it affect the eventual result or you approach has inherently nullified it’s effect.

    Thank you

    • I certainly do round the number of contracts!!

      Watch again and at around 7 min 10 seconds you can see me round it up from 21.69 to 22 contracts!!

      We can only deal in whole numbers of contracts and so we have to round it.

      • Ok.
        So does it matter when you are to compare 2 strike prices, if 1 gives number of contract of 22.19 while the other gives 21.9 and both is rounded to 22?

        I know the premium would be different. I just want to be clear if the fractional round-up is immaterial to the outcome of the options because I’ve seen solutions which recognise over-hedging and under-hedging because of the rounded number of contracts.

        Thank you

      • If the exchange rate moves against us and therefore the options are exercised, then the outcome will obviously be different because different strike prices result in a different ‘worst’ exchange rate. The over or under hedge is a minor issue because the amount involved will be small relative to the overall size of the transaction.
        Obviously if the options are not exercised then any over or under hedge becomes completely irrelevant anyway.

  4. Hi John, very insightful – thank you:

    Quick question – confused as to why you would claim against the buy rate of the spot dollar

    I.e 22 (Contracts) x £31,250 (size) x ( 1.4750 (right to sell ‘put option’) minus 1.4100 (today’s buy spot)

    Why would claim against the buy spot rather than the Sell spot (1.4750 minus 1.4120), seeing as we bought the right to sell?

    Why would anyone buy the option from you when the today’s spot is cheaper?

    Many thanks

      • Many thanks for the very prompt reply –

        I think I get it: the original option was taken in the home country to sell the pound at an agreed rate (as we would need to get rid of the pound to buy the dollar in order to pay) – and we claimed this back as part of exercising the option – because our strike price was favourable to the April spot?

  5. Good day Sir,

    Many many thanks for these lectures, they have been very helpful indeed. However, there are no lectures for foreign currency and interest rate swaps, can you kindly advise on when these will be put on the website.
    Awaiting your reply.

  6. Hi tutor, I’m stuck in options concept, I’m sorry if it’s irritating to ask some topic, please solve this one, could u plz explain where am I wrong in the solved example (example from lecture 3 on currency options- open tuition course notes)
    Payment $1m

    Option position £687500
    Premium £5556
    Overhedged (£9959)
    (31250x22x1.475
    =$1014063_$1m
    Overhedged by $14063
    Selling there dollars and get local £, so divide by 1.4120

    • The difference between your total and the total in the answer at the back of the notes is GBP 30, which is irrelevant for the exam.
      (The reason for it is the difference between the spot buy and sell rates at the date of the transaction. Strictly the method in the notes is the way it works in practice. The other way of doing it is effectively calculating the profit on the options based on 1.4120 instead of on 1.4100. However, that doesn’t matter in the exam – either way would get full marks. The reason I prefer the method in the notes is partly because it is the way it works in real life, but also because when you come to interest rate options there is no choice – it has to be done effectively that way).

  7. Please solve this,
    ABC Inc, a USA based Co.is expected to make payment of £530000 in 3 months, 3 months spot ($/£) 1.5655
    strike price (£/$) 1.58, premium 2.12 in cents, contract size £31250
    Solution
    Premium=$11263, No of contracts are 17
    Answer with BPP METHOD is $848681
    Answer with open tuition
    At spot rate $829715
    Claim back ($7703)
    (1.58_1.5655=0.0145x17x31250)
    Premium $11263
    Net payment =$833275
    Where am I wrong?

    • Firstly, either you have mistyped the question or BPP had made a typing error. The 3 month spot rate is quoted $/GBP whereas the strike is quoted GBP/$ – this could not be the case.

      If I assume that the strike is really $/GBP 1.58, then the option would not in fact be exercised – it would be cheaper to buy GBP’s at spot rather than at the strike.

      Therefore, the end result would be to convert at spot (829715) and still pay the premium (11263) even though it was not exercised. This gives a total of $840978.

      (The BPP answer you type has wrongly assumed that the option is exercised. If they did exercise, then rather than receive back money on the option they would be having to pay in money (7730). This would result in a total payment of 829715 (at spot) + pay out 7703 (on the option) + pay out 11263 (option premium) giving a total of 848681- which is the same as the BPP answer.)

      It either means that BPP have got it wrong, or somewhere you have mistyped the question.

      • Ok thanks you, may be BPP misprinted
        But if spot is 1.5655 and strike is 1.58, it’s the payment case so exercising the option is better or not?

      • It is better to not exercise the option (because multiplying the GBP 500,000 by the spot rate will mean paying fewer $’s than using the strike price).

  10. Thanks a lot sir. we appreciate your efforts to helps students. But sir Problem is that, in notes and books we have very basic example but in exam we are facing more complex question. how to handle this issue and from where we can find more material to practice.

    • The lectures – as with all courses – go through the techniques needed.

      The exam questions are not more complex in terms of the techniques, but certainly are more complex in terms of sorting through the information and deciding which techniques to use.
      You can only master this by practicing exam-standard questions (once, obviously, you are happy with the techniques involved and really understand them) and for this – as we make clear throughout the website for all the exams – you must have a Revision/Exam Kit from one of the approved publishers, and you must work through all of the questions properly and learn from them.

      If you have any problems with any of them (or with understanding the answers) then obviously ask in the Ask the Tutor Forum and we will try and help.

  12. Hi Sir,
    I have problem in calculating cross rate,
    Example, Consider the following.
    $/Pound sterling
    Spot……………………One year forward rate
    1.7985-1.8008………1.7726-1.7746
    SF/Pound Sterling
    Spot………………….. One year forward rate
    2.256-2.298…………2.189-2.205
    Now, What is the cross rate for converting SF to Dollars?

    My second problem lie in foreign Tax credit, I don’t know how to calculate the value for Foreign tax credits.

    Thank you for your continue support.

    • 1 SF will buy 2.298 GBP., and 1 GBP will buy 1.7985 USD.
      So….1 SF will buy 2.298 x 1.7985 USD

      With regard to tax credits, if (for example) tax has been charged at 25% in one country! and the profits are remitted to another country where the rate is 30%, then there is an additional 5% chargeable in this other country

  13. Whether to buy Put Option or Call Option .I have tried to memorize following
    US Company Receiving GBP (Any currency other than $)- PUT ( Always)
    US Company Paying GBP ( Any Currency other than $)- CALL ( Always)
    Non US Company Receiving – $ – CALL ( Always)
    Non US Company Paying – $ – PUT ( Always)

    Whether this is right way of doing and whether it would serve exam purpose.

    • The lecture explains this!

      These are traded options and so you do not actually have the right to convert at the option rate. What happens is that you convert at the spot rate and then ‘claim’ on the options and so get back the difference.
      Watch the lecture all the way through – it is all explained.

  15. Thank you to the tutor and Open Tuition for the wonderful lecture 🙂

    However I have a q on the premium part.
    The premium was initially established in $ and since the company in q is a UK company, the impact should be shown in Pound and thus the need for conversion to Pound arises. I understood that part. However why was the the conversion rate used $ 1.4850 (buying rate) and not $ 1.4870 (selling rate) since we are selling $ to receive pounds?

    Thank you once again for a good lecture 🙂

    • Hey 🙂 I understood your question. And its a good one btw 🙂 What i believe is, since its a premium PAYABLE in dollars, we have to BUY dollars to pay for the premium. And therefore, in order to buy the dollars, we are using the Buying Rate (1.4850).
      So in short, we can say, we are selling 5556 pounds to buy 8250 dollars 🙂 I hope i made sense 😀

  16. Hi Markn, Thanks for your explanation. I finally understand that the tutor said, when we exercise the option, we are actually claiming back $ from the option writer. So, the currency we hold now is $, we will sell $ to buy Pound. Therefore, buy rate of $1.4120 is used. Anyway, thank you so much.

  17. Hi Estherpang87, the reason he uses 1.4120 is because we are receiving the pounds to offset against the amount we are convering to pay the $1m. Some tutors always advise us to choose the rate in which we receive less or pay more – it’s just an exam tip. Always choose a rate that is unfavourable to you…

  18. Hi sir, in this example, when we calculate the amount attributable to option exercised, our working is [22 x 31250 x (1.475 – 1.4100)] / 1.4120 = 31649 pound.

    In my opinion, the rate of 1.4120 is a buy rate. but in this case, we actually sell pound to buy $ to settle payment. Shouldn’t we use sell rate of 1.4100, instead of the buy rate of 1.4120?

    Thank you sir.

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