Currency Options

FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

Question

A UK company, PrimeCare Plc, will receive US$2 million in six months’ time. It is now 20th March. The company is not sure whether the US dollar will rise or fall in value against sterling over the next few months, and it has decided to hedge its exposure to currency risk using traded currency options.
On the London Stock Exchange, traded currency options are available in a contract size of £31,250. Options are priced in cents per £1. Assume that option contracts expire on 20th of each month.
The following option prices are currently available:

Exercise price	Calls	Puts
	June	September	June	September
1.8500	1.4	1.9	4.0	5.1

The current spot exchange rate (US$/£1) is 1.8325–1.8375.

Required
(a) Explain how the company’s currency exposure could be hedged using traded currency options.
(b) Show what would happen if the options are still held by the company at expiry and the spot exchange rate is $1.9150–1.9200.

Answer

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Tags: Currency Options, Exchange Rates, Financial Risk Management, Foreign Exchange Risk, Hedging, Sterling, Traded options, US Dollar
Level: Level 2

Topic: Hedging with options

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

Question

Riverfront Plc has just delivered a major export order to a customer in Canada at a price of $35 million payable in six months’ time and as the company’s finance director you are concerned about the potential impact of currency volatility on the profitability of this particular order.
You have obtained the following exchange rate and interest rate data at the close of business today:

Spot rate (ZMW/$)	ZMW 5 – ZMW 6
6-month forward rate (premium)	0.08 – 0.12

Annual interest rates:

	Deposit	Borrowing
Zambia	10%	14%
Canada	5%	6%

Riverfront Plc’s bank has quoted a premium of ZMW 10,000 (payable up-front) for a $35 million six-month over-the-counter currency put option with an exercise price of ZMW 5.6 = $1.
Riverfront Plc has the ZMW 10,000 available on deposit at the current time and would leave it on deposit for the next six months if it was not used to purchase the currency put option.

Required
(a) Calculate the unhedged ZMW value of the $35 million receivable if, in six months’ time, ZMW has depreciated by 5%. Explain how this compares to the ZMW value of the sale when it was made.

(b) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a forward exchange contract.

(c) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a money market hedge and calculate the effective forward exchange rate achieved.

(d) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use an over-the-counter currency put option and the spot exchange rate in six months’ time is:

(1) ZMW 5 = $1

(2) ZMW 6 = $1

Answer

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Tags: Currency Options, Currency Risk, Exchange Rates, Hedging, Put Option
Level: Level 2

Topic: Foreign exchange risk and currency risk management

Tag (SQ): Currency Options

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FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

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FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

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FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

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