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Dear Tutor,
please advice on point a) of Kenduri question.
In regards to option why we are not calculating gain/loss on option, just amount to pay based on exercise price, premium, and unhedged amount? Shouldn’t we state if we exercise option or not? and if so what is gain on option?Thank you
Firstly there is never going to be a loss using options!! If there was going to be a loss then they would not be exercised!
Secondly, we do not know what the future spot rate will be, and so the calculations on options are showing what the worst outcome can be.
Have you watched my free lectures on foreign exchange risk management?
Yes I did watch lectures. This what I wanted to double check, that there is no future spot rate, I was not sure about that.
So just to clarify worst case scenario is:
Amount to be paid in foreign currency/Exercise price
+premium
+under/over hedge based forward rate (if applicable)IF spot rate would be given, and currency movement would be favourable, we are not exercising option but convert on favourable spot rate. Premium is still paid obviously.
Thanks to option, max downside risk is amount of premium paid.
Thank you for explanation in advance.
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