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Hedging futures and options

A U.S. based MNC expects to receive royalty payments totaling £1.25 million next month. It is interested in protecting these receipts against a drop in the value of the pound.

It can sell 30 day pound futures at a price of $1.6513 per pound or it can buy pound put options with a strike price of $1.6612 at a premium of 2.0 cents per pound.

The spot price of the pound is currently $1.6560. And, if the pound's price in 30 days is $1.6400 then the futures rate is $1.6410.

Calculate the associated dollar gain or loss associated with hedging with futures vs. options.

Please show your calculation steps.

In your opinion, when should MNC aggressively hedge their foreign exchange risk?

Solution Preview

Option 1: Hedge with futures
Sell 1.25 million 30-day pound futures today at $1.6513 each, for a total of 1.25 million * $1.6513 = $2,064,125 today. The £1.25 million in royalty payments you receive next month will be canceled by the £1.25 million you pay on the futures, so your only cashflow is $2,064,125 today.

Option 2: Hedge with options
Buy 1.25 million pound put options with strike $1.6612 at $0.02 each, for a total ...

Solution Summary

Hedging futures and options are examined.