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Hi Sir,
I encountered this question but still a bit confused on the answer: Section B (Keermen Co)
Which TWO of the following would be appropriate methods of minimising the foreign exchange risk on the future receipts from French customers if the MD’s expectations about the exchange rate are correct?
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Sell Euro denominated futures up front and buy back on close out. (1 Mark)
A put option on Euros. (1 Mark)
When Kermeen Co receives the Euros from the French customers, it will sell them to buy £.Selling Euro denominated futures contracts up front on the invoice date of the transaction and buying them back on close out at (or around) the settlement date of the invoice would effectively fix the Euro sell price immediately. The close out of the futures contracts and the actual sale of the Euros received from the French customer would offset each other, removing the exposure to exchange rate movements between the invoice date and the settlement date.
A put option gives the right to sell a currency at a predetermined rate, so an option on Euros would give the right to sell Euros and would be appropriate here. A call option would give the right to buy Euros at a predetermined rate, but the Euros are being sold rather than bought so this option would not be appropriate.
You will have to say which bit of the answer you are confused about, because what you have copied out is correct.
I do explain the way we use futures and options in my free lectures.Is this correct? When we talk of Receipts we are talking of selling now and buy later and having a put option in order to minimise the risk of foreign exchange transactions?
However for payment we can buy now and sell later and have a call option?
Foreign exchange transactions really gives me still confusions. Please help me Sir.
A put option on Euros is the right to sell Euros at a fixed rate. They are receiving Euros, therefore they need to sell Euros and therefore they will want a put option.
If they need to pay Euros they would need to buy Euros and so they would buy a call option – the right to buy Euros at a fixed rate.
You do not buy options now and sell later – that is what you do with futures.
Please watch my free lectures because I explain all this, with examples. (Although, as I explain in the lectures, you cannot be expected to do calculations on these in Paper FM, but you are expected to know how they work).
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