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Finance: Put & call options, currency contracts, spot rates, economic exposure

1.- Which of the following is NOT true for the writer of a put option?

a.-The maximum loss is limited to the strike price of the underlying asset less the premium.
b.-The gain or loss is equal to but of the opposite sign of the buyer of a put option.
c.-The maximum gain is the amount of the premium.
d.-All of the above are true.

2.- A call option on euros is written with a strike price of $1.30. Which spot price maximizes your profit if you choose to exercise the option before maturity?

a.-$1.20
b.-$1.25
c.-$1.30
d.-$1.35

3.- Which of the following is the most likely strategy for a U.S. firm that will be receiving Swiss francs in the future and desires to avoid exchange rate risk (assume the firm has no offsetting position in francs)?

a.- purchase a call option on francs.
b.- sell a futures contract on francs.
c.- obtain a forward contract to purchase francs forward
d.-all of the above are appropriate strategies for the scenario described.

4.- Losses from __________ exposure generally reduce taxable income in the year they are realized. __________ exposure losses are not cash losses and therefore, are not tax deductible.

a.- transaction; Operating
b.- accounting; Operating
c.- accounting; Transaction
d.- transaction; Accounting

5.- Plains States Manufacturing has just signed a contract to sell agricultural equipment to Boschin, a German firm, for 1,250,000. The sale was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in Euros rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
The spot exchange rate is $0.8924
The six month forward rate is $0.8750
Plains States' cost of capital is 11%
The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
The U.S. 6-month lending rate is 6% (or 3% for 6 months)
December put options for 625,000; strike price $0.90, premium price is 1.5%
Plains States' forecast for 6-month spot rates is $0.91
The budget rate, or the lowest acceptable sales price for this project, is $1,075,000 or $0.86
If Plains States purchases the put option, and the option expires in six months on the same day that Plains States receives the 1,250,000, the firm will exercise the put at that time if the spot rate is $0.91.

a.-True
b.-False

6.-Which of the following statements are correct about economic exposure?

a.-Transaction exposures to exchange rates, interest rates, and commodity prices over the short-to-medium run are an integral part of economic exposure.
b.-Managing the strategic implications of all changing macroeconomic variables cannot be accomplished using only the financial markets.
c.-Effective economic exposure management must be based on strategic operating decisions made mainly by marketing and production managers in response to expected changes in input and output prices, and the impact of changing demand for the company's products.
d.-All of the statements above are correct.
e.- Only statements b and c are correct.

7.-Management must be able to predict disequilibria in international markets to take advantage of diversification strategies.
a.-True
b.-False

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1.- Which of the following is NOT true for the writer of a put option?

a.-The maximum loss is limited to the strike price of the underlying asset less the premium.
b.-The gain or loss is equal to but of the opposite sign of the buyer of a put option.
c.-The maximum gain is the amount of the premium.
d.-All of the above are true.

Kindly think in the following terms: The amount of premium is the amount that the writer of a put option is willing to pay to enter into the contract over and above the spot price. For, example if the spot price is $1 and the premium is $0.05 then the writer is willing to enter into the contract for the put option by paying $0.05 at the time of entering into the contract. His maximum gain or loss is dependent on the spot rate when he makes the put. Continuing with our example if the spot price is $0.70 when the writer makes the put then he gains $1.00 less $0.70 that is $0.30. So, his gain is dependent on the spot price when he makes the put and not on the premium he has paid when he has written the contract.

2.- A call option on euros is written with a strike price of $1.30. Which spot price maximizes your profit if you choose to exercise the option before maturity?

a.-$1.20
b.-$1.25
c.-$1.30
d.-$1.35

Please understand what a call option is. When the call option is made, and the strike price is $1.30 then the person making the call has to pay $1.30 to purchase the euros that he needs. In contrast he will receive $1.35 from the spot market so this is the price that maximizes his profits. If the spot rate is anything else say $1.25 then he will make a loss of $1.30 - $1.25. This is not the profit maximizing point.

3.- Which of the following is the most likely strategy for a U.S. firm that will be receiving Swiss francs in the future and desires to avoid exchange rate risk (assume the firm has no offsetting position in francs)?

a.- purchase a call option on francs.
b.- sell a futures contract on francs.
c.- obtain a forward contract to purchase francs forward
d.-all of the above are appropriate strategies for the scenario described.

Please think of the following: The forward contract to purchase francs will be of the same amount that the US firm is going to get in future. This is a hedging transaction. The US firm will ...

Solution Summary

In a 1565 word solution (including the problems), the responses are thoughtful and clear in explanation of the answers.

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