Money Market Versus Call Option Hedging. You expect that inflation in the United

Question

Money Market Versus Call Option Hedging. You expect that inflation in the United States will be 3%, versus 5% in the United Kingdom. The expected spot rate in one year is $1.8756. The spot rate of the pound as of today is $1.8000. The annual interest rate in the United States is 6% versus an annual interest rate in the United Kingdom of 8%. Call options are available with an exercise price of $1.79, an expiration date of one year from today, and a premium of $.03 per unit. Your firm in the United States expects to need 1 million pounds in one year to pay for imports. Use the unhedged strategy to deal with the exchange rate risk. Estimate the dollar cash flows you will need as a result of an unhedged strategy.

Explanation / Answer

Present spot rate of the pound =$1.80

Expected spot rate in one year =$1.8756.

Annual interest in United states=6%.

Amount in pounds to be paid for imports =1,000,000 pounds.

Amount in dollars equivalent to the 1,000,000 pounds after one year =1,000,000*$1.8756.

=$1,875,600.

As hedging is not done by using the call option the amount that needs to be paid after one year =$1,875,600.

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.