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Deat co is a US com and is considering the use of an option to hedge currency risk on a Euro receipt. Its bank has offered an over counter option with an exercise price of 1.1350 euros per $. This is also the current price.
Which of the following statement concerning the option are true?
1) the options require a premium to be paid only if the option is used
2) If the $ was to weaken against Euro. Deat will let the option lapse
3) An imperfect hedge will result as the option will be for a standard amount of currency and a whole number of contracts may be used.
Why the answer is 2 and not 1??With options, a premium has to be paid whether or not they end up using the option, so 1 is not true.
If the $ weakens then 1 Euro will buy more $’s and therefore they will not use the option but would prefer to convert the Euro receipt at the better spot rate, so 2 is true.
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