A U.S. exporter owes £3,500,000 in six months and is planning to use an option m

Question

A U.S. exporter owes £3,500,000 in six months and is planning to use an option market hedge. The contract sized for options on the British Pound is £100,000. The strike price is X($/£)=1.51 for both calls and puts. The call premium is $0.05/£ while the put premium is $0.03/£. The spot rate next year is expected to be either S1($/£)=1.49 or S1($/£)=1.54 while the current spot rate is S0($/£)=1.51. The interest rate in the U.S. is i$=0.25%. Show how to implement an option market hedge. Show all the cash flows involved and the value of the payable at maturity after the option hedge.

Explanation / Answer

Thus, Cash inflow will be as follows:

$53,19,781.25

Call Option Let Spot Rate Dollar per pound is 1.49 Amount of Exposure £ A 35,00,000 Contract size £ B 1,00,000 No. of contract C=A/B 35 Let spot Rate is $/£ D 1.49 Strike rate as given in question $/£ E 1.51 Exercise of option is not profitable Sale price in spot market F=A*D 52,15,000 Less:Premium paid G 1,75,000 Less: Interest on premium paid H 218.75 Net Proceeds F-G-H 50,39,781.25

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