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Dear Mr Moffat,
I am using the BPP revision kit, looking specifically at question Kenduri Co (6/13). There is a calculation there for the currency options that I don’t understand.
Consider:
– contract size GBP 62,500
– spot USD/GBP 1: 1,5938-1,5962
– exercise price 1,62
– the company needs to pay USD 2,400,000 in 3mWe therefore buy 23 contracts – 3m put options and need to calculate total payment for the option.
In the revision kit, we have:
Payment = 23 x 62,500= GBP 1,437,500
Premium= (23x 0,0342x 62,500)/ 1,5938 = GBP 30,846
Unhedged amount= 2,400,000-(1,437,500x 1,62)=USD 71,250
Hedging using fwd market =USD 71,250/1,5996= GBP 44,542
Total payments = GBP 1,437,500+ GBP 30,846 + GBP 44,542 = GBP 1,512,888My logic is different:
Payment = USD 2,400,000/1,5938 = GBP 1,505,835
Premium = as above =GBP 30,846
Exercise since exercise price>spot= > claim difference = 23x 62,500x (1,62-1,5938)=USD
37,662 / 1,5938= GBP 23,630
Total payment = (1,505,835 – 23,630)-30,846 = GBP 1,513,051I don’t understand what I am doing wrong, and also don’t get the unhedged amount calculation from the revision kit. Perhaps you can briefly explain?
Thank you very much!
What you have done is fine (and strictly is the correct way to do it).
Apart from the unhedged amount, any difference remaining in the final answer is just rounding and is irrelevant in the exam.
The unhedged amount is because (due to the contract size limit), the options are covering 23 contracts x 62,500 = 1,437,500 at an exercise price of 1.62, whereas the actual amount of the transaction is $2,400,000. So the difference of $71,250 is not covered by the options and is therefore still at risk. The way that the company can remove the risk on the $71,250 would be to use forward rates so as to fix the conversion of this amount.
Dealing with an over or under hedge does not carry many marks. If you have time in the exam then obviously do it, but if you are short of time then just mention the possibility without doing the calculations – you would then only lose 1 or 2 marks at most.
Sir I don’t understand the unhedging part in this question. Tried searching for it in your lectures but couldn’t find anything.
Could u please explain what under hedge and over hedge means in general terms and relating to this example as well.
Thanks for all your help‘Unhedging’ is not a term.
If future are used then it is only the contract amount that is covered again changes in the exchange rate. The rest of the amount (whether higher or lower than the amount covered by the contract) is not covered against changes in the exchange rate and is therefore at risk because it will have to be converted at whatever the spot rate turns out to be. The only way of removing that risk would be to use forward rate on that amount and so the exchange rate applying to that amount would be fixed.
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