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1. Hedgehog is a UK-based company which must pay $500,000 to its foreign supplier in 90 days. The current spot rate is $1.60 per £1. Hedgehog purchases an option to buy dollars in 90 days at $1.64 per £1, paying a premium of $0.07 per $1. The spot rate after 90 days is $1.58 per £1.
What will Hedgehog do on the payables’ settlement date?
A.Hedgehog will exercise the option
Note that the premium has become a sunk cost.
If the question said that hedgehog is “planning to” purchase an option, and asked us if we should purchase this option or buy dollars in the spot market after 90 days, then should we consider the premium a sunk cost?
The premium is only a sunk cost here because it has already been paid, as the company has already purchased the option, right?
Hedgehog will exercise the option on the payables’ settlement date.
The premium paid for the option is considered a sunk cost because it has already been paid and cannot be recovered.
If the question stated that Hedgehog is “planning to” purchase the option and asked whether they should purchase the option or buy dollars in the spot market after 90 days, then the premium would not be considered a sunk cost because the decision to purchase the option has not been made yet.
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