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

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 money market hedge strategy to deal with the exchange rate risk. Estimate the dollar cash flows you will need as a result of a money market hedge.

Explanation / Answer

Money Market Hedge:

Amount in pound to be invested = 1,000,000 / 1.08 = 925,926

Amount of $ needed to convert into pound = 925,926 x 1.8 = $1,666,667

Interest and principal on $ after one year = $1,666,667 x 1.06 = $1,766,667

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

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