- 15 Marks
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.
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