A U.S. exporter owes £3,500,000 in six months and is planning to use an option m
ID: 2751419 • Letter: A
Question
A U.S. exporter owes £3,500,000 in six months and is planning to use an option market hedge. The contract sized for options on the British Pound is £100,000. The strike price is X($/£)=1.51 for both calls and puts. The call premium is $0.05/£ while the put premium is $0.03/£. The spot rate next year is expected to be either S1($/£)=1.49 or S1($/£)=1.54 while the current spot rate is S0($/£)=1.51. The interest rate in the U.S. is i$=0.25%. Show how to implement an option market hedge. Show all the cash flows involved and the value of the payable at maturity after the option hedge.
Explanation / Answer
1. how to implement an option market hedge.
Buy Contract to Hedge total owes & paid premium on cantract
If End of the Preiod Spot rate is Less than contract price than Dont exercise contract and Paid Owes at Spot rate
If End of the Preiod Spot rate is Higer than contract price than exercise contract and Paid Owes at Contract Price
Hedge with Contract
No. of Contract= £3,500,000 / £100,000 =35Contract
He want to buy $ at the end of Six Months than Call Option will be choose
Call Premium Paid £100,000*0.05$=5000$*35Contract=175000$ Payable for Spot rate ($/£)=1.51
End of Six Month If S1($/£)=1.49 he will not exercise contract for benefits of Less payment
Than Amount Payable = 1.49*100000*35 = 5215000$
Assume Call Premium Paid by Finance 175000$*0.25%*6/12=218.75$#
Total Payment at the End of Six Months = 5215000$ + 175000$ + 218.75$ = 5390218.75$ Ans.
End of Six Month If S1($/£)=1.54 he will exercise contract for benefits
Than Amount Payable = 1.51*100000*35 = 5285000$
Assume Call Premium Paid by Finance 175000$*0.25%*6/12=218.75$
Total Payment at the End of Six Months = 5285000$ + 175000$ + 218.75$ = 5460218.75$ Ans
#There was Differ answer if Call Premium not by Finance
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