A U.S. importer will have a net cash outflow of BP3 million for goods bought. Th

Question

A U.S. importer will have a net cash outflow of BP3 million for goods bought. The payment date will be late September 2014. On April 20, 2014, the U.S. importer locks in the maximum dollar cost of buying BP 3 million by buying PHLX calls on BP, with a strike price of $1.68/BP and an expiration date of October 30, 2014. The option premium on that date is $0.01/BP. The options are available in multiples of BP 0.25 million. There is a brokerage commission of $40 per option contract.

(1)   What are the maximum possible dollars the US importer could pay for BP3 million?

(2) The spot rate on the September payment date turns out to be $1.70/BP. The importer can either exercise the call options or sell them back at their market value. Assume that he can sell them back at $0.0205 per BP if he chooses to. What is the actual dollar cost of buying BP3 million?  

Explanation / Answer

1. Number of option contracts bought = 3 million / 0.25 million = 12 contracts

Maximum dollar cost occurs when exchange rate at option expiration is greater than or equal to strike price of 1.68

Importer will pay 3 million * 1.68 = 5.04 million = 5,040,000

In addition, option premium paid = 3 million * 0.01 = 0.03 million = 30,000

Brokerage commission = 40*12 contracts = 480

So total dollar cost = 5,040,000 + 30,000 + 480 = $ 5,070,480

2. If importer exercises the call option, he will pay 1.68 per BP

If he sells option at 0.0205 and instead buys BP at 1.70, his net cost = 1.70-0.0205 = 1.6795

As selling option leads to lower net cost, he will choose this option.

Dollar cost for 3 million BP = 3 * 1.6795 = 5.0385 million = 5,038,500

So total dollar cost = 5,038,500 + 30,000 + 480 = $ 5,068,980

Hope this helped ! Let me know in case of any queries.

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