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Dear John,
Could you pls explain the answer for the outcome when the option is not exercised. We don’t know spot rate at the transaction date 31 May, and they apparently refer to the lock-in rate, but what are they exactly doing here? Why they look for some x rate here and what it has to do with finding the result if option is not exercised?
Thank you a lot!
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If Nutourne Co allowed the option to lapse, it would obtain the same receipt as under the futures if the US$/CHF spot rate was x, such that:
12,692,225 = 12,250,000x – 105,350
12,250,000x = 12,692,225 + 105,350
so that x is US$1·0447 = CHF1.The question is asking which of futures and options will give the higher receipt.
In both cases it is only relevant to look at the contract amount (because the amount not hedged remains the same and would be hedged by a forward contract).
We already know from the earlier workings that if the options are exercised then futures give the bigger receipt.
The question is which would give the bigger receipt if the options are not exercised. If they are not exercised then the conversion will be at spot is on the date of the transaction, and so we need to work out what the spot rate will have to be to give the same receipt as the futures.
Ignoring the ‘remained on the forward market’ for the reasons I have written above, then futures give 12,692,225. Not exercising the options and therefore converting at spot will give us 98 (contracts) x 125,000 (contract size) x X (the spot rate we are trying to find).
This equals 12,250,000 XThere is the premium payable on the options of 105,350 whether or not we exercise.
So for not exercising the options to be as good as using futures, then
12,250,000 X – 105,350 = 12,692,225
It is then simple algebra to calculate X – the spot rate at which having bought options would end up being better than using futures 🙂
Thank you John!
The queston though didn’t ask what shall the spot rate be for non-exercised option to be
the same as futures. It directly asked which derivative will give the highest recepit.
Apparently between the lines the question was as you clearly explained ).But the question does ask which of futures and options would give the higher receipt both when they are and are not exercised.
If the options are not exercised then which gives the higher receipt depends on what the spot rate turns out to be.
sorry, I’m still confused.
Does the result mean only when spot rate is >= 1.044, the company will exercise, and it gives higher receipt than futuresbut if <1.044, futures give higher receipt, and company should not exercise the options with exercise price 1.0375?
The question is asking whether they should use futures or should use options – they will not use both at the same time.
If they do use options then they will exercise them if the spot rate is lower than 1.0375.
Using options would only be a better policy than using futures is the spot rate turned out to be higher than 1.044. In that case they would obviously not be exercising the options and would end up getting a bigger receipt than had they used futures instead.
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