Suppose that a French Pharmaceutical (Rx) firm expects to make a payment of 1 bi

Question

Suppose that a French Pharmaceutical (Rx) firm expects to make a payment of 1 billion for the foreign acquisition of a British Pharmaceutical (Rx) firm. As the chief financial officer (CFO), you need to decide whether you should hedge against exchange rate risks in the next six months. If you decide to hedge against exchange rate risks in the next six months, you would use either the currency forward or currency option market. You are quoted the following spot rate, forward rate and options strike prices and premiums.

          Today’s spot rate                                6 month Forward rate

          €1.1400/                                          €1.1500/

Options                          Strike Price           Premium

Put option on                €1.1600/             €10 million

Call option on               €1.1550/             €10 million

Explain briefly three factors why you should hedge against exchange rate risks.   [8%]

Explain how you can use the currency option market and currency forward market to hedge against exchange rate risks. Be sure to discuss the specific risks being hedged, and five differences (maturity and settlement of contract, pricing and margin/collateral requirement, counterparty risks, liquidity, and potential profits/losses) between the currency option and currency forward markets. [20%]

If the spot rate in 6 month is €1.1700/, explain the potential gains or losses from using the currency option market.   [6%]

If the spot rate in 6 month is €1.1300/, explain the potential gains or losses from using the currency forward market.   [6%]

Explanation / Answer

A company hedges against exchange rate risks

a) protect margins

b) To have a stable and predictable cash flow

c) To protect against FX rate fluctuations

d) to stay competitve

A currency option gives the buyer the right but not the obligation to buy or sell a currency at a predefined exchange rate. To hedge against currency rate fluctuations, we can either buy a call option or a put option.

In case of a currency forward market, the exchange rate is locked in today at which a transation will happen in a future date.

The difference between a forward contract would be that in case of option a premium is paid upfront whereas it is not required in case of forward contract and also the underlying position is usually large in case of a forward contract viz-a-viz currency options and hence exposes the company/investor to a larger amount. In case of an option the buyer has the right but not the obligation to excercise the option whereas in case of a forward contract it a binding between the two entities entering into the contract. Options are usually more liquid as compared to forward contracts.

If the spot rate in 6month is 1.1700 then the put option would expire worthless and the call option would make a gain 0.01(1.17 - 1.16) * 10 million = Euro100,000

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