Hello Sir, Kindly help me understand why in the answer we are not using the exercise price of 1.9000 anywhere except to get the number of contracts why are we not doing this: 19*31250*1.900 divided by forward rate assuming that it will be the spot rate?
CME currency options prices, $/£ options £31,250 (cents per pound)
CALLS PUTS
Sept Dec Sept Dec
1.8800 4.76 5.95 1.60 2.96
1.9000 3.53 4.70 2.36 4.34
1.9200 2.28 3.56 3.40 6.55
Forward rate=1.9029
$ net import- 1150000
answer:
As dollars need to be purchased, Lammer will need to buy December put options
on £.
Exercise
price $ £ No. of contracts
1.8800 1,150,000 611,702 19.57
1.9000 1,150,000 605,263 19.37
1.9200 1,150,000 598,958 19.17
It is assumed that Lammer will underhedge using 19 contracts and will purchase the
remaining dollars in the forward market (in reality it would probably wait and use the
spot market in five months’ time); 19 contracts is £593,750.
Exercise price $ Premium$ Premium £ at spot Underhedge$
1.8800 1,116,250 17,575 9,175 33,750
1.9000 1,128,125 25,769 13,452 21,875
1.9200 1,140,000 38,891 20,302 10,000
Worst-case outcomes if the options are exercised:
Exercise price Basic cost (£) Premium Underhedged £at forward Total
1.8800 593,750 9,175 17,736 620,661
1.9000 593,750 13,452 11,496 618,698
1.9200 593,750 20,302 5,255 619,307
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Lammer plc
4y ago#1We can not assume that the spot rate will be equal to the forward rate.
The answer is showing the worst outcome (i.e. that the options are exercised). The premium is payable immediately (at the current spot rate). We know in advance what the underhedge is going to be and therefore we use the current forward rate on this.
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