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Sir, if we exercise an foreign exchange option, there are two ways to calculate the net outcome:
1. Convert at spot, add claim on option and subtract premium (As you do it in your videos)
2. Convert at option rate, add/subtract any difference in hedge at closing rate due to contract size being different than business transaction and subtract premium.
Am I right?
The questions done in the BPP study text were done with 2 and I obtained the same result when I did them with 1 I find it easier, except for the following question:
Date: 15 May
Payment: 600,000 Euros
Option rate: 0.7700 Euro : 1$
Options contract size: 10,000 Euro
Option premium: 3.57
Spot on payment date: 0.7500 Euro : 1$We need 60 contracts.
Premium is $21,420 (0.0357 x 10,000 x 60)
We exercise option because 0.77 is better than 0.75On transaction date:
Payment on spot: 800,000 (600,000 / 0.75)
Claim on option: ????? (I am not able to calculate this)
Premium: 21,420
Total (from the book’s answer): 800,641How can we calculate the claim on this question?
It is because the exchange rates are quoted the other way round.
The spot on the date of the transaction is €/$ 0.75, which is the same as $/€ 1.3333 (1/0.75)
Similarly the option rate is $/€ 1.2987 (1/0.77)So the gain on the options is 60 x 10,000 x (1.3333 – 1.2987) = $20,760
So the net results is 800,000 – 20,760 + 21,240 = 800,480
(the difference is simply due to the rounding of the converted exchange rates).The examiner sometimes uses one method and sometimes uses the other method – you get the marks either way (and most of the marks are for proving you understand options, rather than for the precise calculations 🙂 )
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