Explore BrainMass

Explore BrainMass

    Hedging strategy for export earnings using options

    Not what you're looking for? Search our solutions OR ask your own Custom question.

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    See the attached file.

    A company finance director is expecting to receive US$2.1 million in export earnings in 90 days time. At that time she will need to purchase sterling. The spot rate is currently $1.35/£ but she anticipates that it may rise significantly before the earnings arrive. She believes that the best hedging opportunity is offered by a foreign currency option and discovers the following quotes for 90-day option on the Chicago exchange:

    Option strike price premium
    Put on sterling $1.40 $0.0810/£
    Call on sterling $1.40 $0.0276/£

    The contract size is £62500

    a) Using these quotes describe a suitable hedging strategy. Briefly explain your answer.

    b) How many contracts would you advise the finance director to buy or sell and what is the break-even price ?

    c) If the spot rate at expiration is $1.45, what are the company's net sterling receipts from the transaction?

    © BrainMass Inc. brainmass.com December 24, 2021, 9:00 pm ad1c9bdddf
    https://brainmass.com/business/international-finance/hedging-strategy-export-earnings-using-options-334861

    Attachments

    SOLUTION This solution is FREE courtesy of BrainMass!

    Please see the attached file.

    A company finance director is expecting to receive US$2.1 million in export earnings in 90 days time. At that time she will need to purchase sterling. The spot rate is currently $1.35/£ but she anticipates that it may rise significantly before the earnings arrive. She believes that the best hedging opportunity is offered by a foreign currency option and discovers the following quotes for 90-day option on the Chicago exchange:

    Option strike price premium
    Put on sterling $1.40 $0.0810/£
    Call on sterling $1.40 $0.0276/£

    The contract size is £62500

    a)       Using these quotes describe a suitable hedging strategy. Briefly explain your answer.
    Since sterling is to be purchased when the export earnings arrive, the finance director needs to go long on (purchase) call options on sterlings
    Call option with a strike price of $1.40 is purchased
    A call option protects against an increase in price
    If the price of sterling in the foreign exchange market (after 90 days) is more than $1.40 per pound, call option would be exercised and pound purchased at
    $1.40 per pound using the call option
    If the price of sterling in the foreign exchange market is less than $1.40 per pound, call option would be worthless and pound purchased at the market exchange rate
    b)       How many contracts would you advise the finance director to buy or sell and what is the break-even price?
    Since the strike price (rate at which) sterling is to be purchased is $1.40 and the export earnings are $2,100,000
    Amount of sterlings that can be purchased = 1,500,000 pounds =2100000/1.4
    Contract size= 62,500 pounds
    Therefore, number of contracts required= 24 contracts =1500000/62500

    Since the finance director has to purchase sterling, buy 24 contracts on call option

    Premium paid for the call option= $0.0276 /£
    Strike price= $1.40 /£
    Break even price= $1.4276 /£ =0.0276 + 1.4

    Call option is valuable at expiry if market exchange rate is greater than the strike price
    Premium on option is paid upfront; this cost has to be recovered for calculating break even

    Thus, If the price of sterling at the end of 90 days is $1.4276 /£, there would be no profit/loss from the hedged position

    c)       If the spot rate at expiration is $1.45, what are the company's net sterling receipts from the transaction?
    With a hedged position total price paid (when the option is exercised) is strike price plus the premium
    Strike Price per pound= $1.4000 /£
    Premium paid per pound= $0.0276 /£
    Total Price paid per pound= $1.4276 /£

    Export earnings= $2,100,000
    Therefore, net sterling receipts= 1,471,000 =2100000/1.4276

    Answer: 1,471,000 pounds.

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    © BrainMass Inc. brainmass.com December 24, 2021, 9:00 pm ad1c9bdddf>
    https://brainmass.com/business/international-finance/hedging-strategy-export-earnings-using-options-334861

    Attachments

    ADVERTISEMENT