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.

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

Total Amount required after one year = 1 million pounds

We can buy a call option for one year at $1.79, then total amount of $ outflow required = 1.79 + 0.03 = $1.82 per pound.

Total for 1 million= 1,000,000 x 1.82 = $1,820,000

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