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Forward contract or Put option

A U.S. firm wishes to hedge Canadian dollar receivables. The firm can enter a forward contract to sell 100,000 Canadian dollars in one year at a rate of F(US$/C$)=0.80. One year from now, the spot price of the Canadian dollar is 0.83.

A) Calculate the U.S. dollars received by the firm (i) if the receivables are hedged with a forward contract and (ii) if they are not hedged.

B) The firm also finds out that it can buy a put option on the Canadian dollar with a one-year maturity for a strike price of $0.82 at a cost of US$0.02 per Canadian dollar.

i) What is the cost of purchasing the put option (contract cost only)?

ii) How many U.S. dollars will the firm have in one year if it purchases and exercises the put option?

iii) Suppose the firm buys the put option. Does it exercise this option? Why or why not?

C) Without knowing what the future spot rate is, would you advise the firm to choose the forward contract or the put option? Explain by identifying the advantages and disadvantages of each.

Solution Preview

A) The forward exchange rate is 0.80 US$ = 1 C$ and the one year spot rate is 0.83US$ = 1C$
(i) If the forwards contract is used, US$ received is 100,000 X 0.80 = $80,000
(ii) if there is no hedge, the spot rate would be used and the amount of US$ received would be 100,000 X 0.83 = $83,000

B) (i) The total cost of the put option is 100,000 X 0.02 = $2,000
(ii) The put option has the rate of 0.82. The ...

Solution Summary

The solution explains hedging using forward contract or put option.