A Brazilian refinery exported many tons of sugar to the U.S. and hence its profi

Question

A Brazilian refinery exported many tons of sugar to the U.S. and hence its profitability relies on a low exchange rate of U.S. dollars per Brazilian real (currently US$0.3315/R$). The risk manager is concerned that an exchange rate above US$0.3600/R$ would impair the company’s ability to make next year’s debt payments. The following option quotes are available to the company (OTC):

Option   Strike Price Premium

December Call on real $0.3400/R$   $0.0045/R$

December Put on real   $0.3400/R$   $0.0132/R$

Explain why buying the call option above can help hedge the exchange rate risk of the company?

Suppose the contract size is R$10,000,000, what is the profit or loss from buying this call if the spot rate in December is US$0.3500/R$?

Explanation / Answer

1.Buying a call option will help hedge the exchange rate risk. A call option is a right, but not an obligation to purchase the underlying commodity at the exercise price.

Hence purchasing the call option will hedge the exchange rate risk, since the refinery can put a upside cap on the movement of the Brazilian real and hence they can exercise the option and exchange the currencies at $0.3400/R$ in case the currency has moved beyond $0.3400/R$. In case the rate is below 0.3400, the firm need not exercise the option and go as per the rate. Hence the firm can make sure that the exchange rate is below US$0.3600/R$

2. If the size is 10,000,000 Real, than in $ terms, the spot would be : 3,500,000$. If they go for the option, it would be 3,400,000$.

Therefore, the profit is $100,000 (3.500,000 -3,400,000). Now we also need to take into account, the price of the option. Which is 0.0045*10,000,000 = 45,000

Hence final profit = 100,000 -45,000 = $55,000

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