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Put Options and Hedging Decisions

Question #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

Correct response:
c. The maximum gain is the amount of the premium

Student Response:
d. all of the above why?

Question #2
Plains estates manufacturing has just signed a contract to sell agricultural equipment to boschin, a German firm, for E (euro) 1,250,000. The sale was made in June with payment due six months later in December. Because this is sizable contract for the firm and because the 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/E
-the 6 month forward rate is $0.8750/E
-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 us 6-month lending rate is 6% (or 3% for 6 months)
-December put options for E625,000; strike price $0.90, premium price is 1.5%
-plains states forecast for 6 month spot rates is $0.91/E
-the budget rate, or the lowest acceptable sales price for this project, is $1,075,000 or $0.86/E

A _____ hedge allows plains states to enjoy the benefits of a favorable change in exchange rates for their euro recievables contract while protecting the firm from unfavorable exchange rate changes.

a. forward
b. call option
c. put option
d. money market

Student response : money market

Correct response: put option
Why?

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Answer:1.
The maximum gain is not the premium received on writing of the option. Let's take the scenario when the scenario when the value of the underlying asset decreases heavily. This situation will induce the buyer of the put option to exercise his put option to sell the asset at the strike price (that's why he purchased the put option, to protect himself from severe declines by paying a small premium to the writer of the option).

Now, the writer of the option is left with the asset. His cost is the strike price of the put option less the premium received on writing the put option. He has the now the choice to dispose the asset at the current market ...

Solution Summary

The maximum gain is not the premium received on writing of the option. Let's take the scenario when the scenario when the value of the underlying asset decreases heavily.

$2.19