C. You are a manager doing business in South Africa. Your business is located in

Question

C. You are a manager doing business in South Africa. Your business is located in the Us, all your costs are denominated in US dollars. You will be paid 50,000 South African Rand. Your costs are $10,000 . .You have two alternative methods to protect yourself from unexpected losses due to declines in the value of the Rand: Alternative 1: You can sell Rand forward. The forward rate is $.26. Alternative 2: You can acquire a European put option. The strike price on the put option is $.265, and the premium whic you must pay whether you exercise the option or not is $.0012 per Rand. Calculate the profits you obtain under each alternative, assuming that the spot exchange rate at the time you receive the $.25. How do these compare to the profit earned you decided not to use either alternative and took your chances on the spot rate?

Explanation / Answer

Alternative 1 - Forward payoff = spot Rate - forward rate

= .25 - .26 = -.01 (negative value indicates profit for short forward holder)

= .01

50000 * .01= 500

12500 + 500 - 10,000(cost) = 3000$

Alternative 2:

Payoff for European put = Max(0,(X-S))

X - exercise price

S - spot price

= .265 - .25 = 0.015 * 50000= 750

Premium = .0012 = 60

Profit = 750 -60 = 690

12500+690 - 10,000(cost) = 3190$

No alternative:

50,000 * .25 = 12,500 - 10000(cost) = 2500$ (profit if no alternative is used).

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