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Hedging Decisions

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Your company has invested $6 million in a new Trilithium crystal technology project. The company will generate huge profits if the project is successful. As a risk hedge, the CFO decides to purchase equal risk derivatives. She buys two hundred 1-year put option contracts with an exercise price of $50. The cost of the option is $3.50 per share. Eight months later, the Trilithium crystal project is a big success and the current price of the underlying security is $66. She decides to sell the option at that time for $1.25 per share. How much has she made (or lost) on the hedging decision?

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Solution Preview

First, we need to see which information we need and what information is just a red herring in this problem.

We don't really need to know how much the company invested in the project. Since the stock hasn't been sold and the options have not been executed, we are just focusing on the options.

The CFO bought 200 1-year put options at ...

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Hedging Decision in Financial Institution

1. In March, a U.S. financial institution manager is expecting to receive 10 million in Euros in June on a loan, and wants to hedge against a fall in the value of the Euro when she needs to convert the Euros to U.S. dollars in June. On this date, spot exchange rate of one Euro = $1.3085 (U.S. dollars). The CME currency future settle rate for Euro currency futures contacts is for 1 Euro= $ 1.3070 (U.S. dollars), with the minimum contract of 125,000 Euros.

a. What position and how many contracts should the financial manager take to hedge against a fall in the Euro?

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