Question details

Like forward contract, creates exposure if underlying proceeds not received
$ 15.00

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Foreign Exchange Risk Management

Short Answer Questions

Which of the following is not strictly a hedge?

A.

Matching

B.

Portfolio approach to forex risk

C.

Multilateral netting

D.

Leads and lags

Question A

Cylinder Options at 1.50 Spot

£

US $ 10 m spot value on receipt

6,666,667

US $10 m call option cost (1.55)

6,451,613

US $ 10 m put option value (1.62)

6,172,840

Outcomes

Bank exercises call

Jones abandons put

Jones uses the receipts to meet obligations

Net proceeds for Jones

£

US $ 10 m sold at 1.55

6

,451,612.90

less option premium (net)

10

,000.00

less 'cost of carry'

147.95

6

,441,464.95

Forward and Spot contract proceeds

£

U S $ 10 m AT 1.62 (forward)

6,172,840

U S $ 10 m AT 1.50 (Spot)

6,666,667

Note:

For comparison purposes between the forward and the cylinder option we have to compare like with like.

The net £10,000 premium on the cylinder option is paid out 90 days before the receipt of the export proceeds.

Thus interest of £147.95 must be deducted.

(10,000 x 0.06 x

365

90

)

 

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Cylinder Options at 1.70 Spot

£

US $ 10 m spot value on receipt

5,882,353

US $ 10 m call option cost (1.55)

6,451,613

US $10 m put option value (1.62)

6,172,840

Outcome

Bank abandons call

Jones exercises put

Jones sells us $ 10 m receipt under option

Net proceeds for Jones

£

Us $ 10 m at 1.62

6

,172,839.51

Less option premium (net)

10

,000.00

Less 'cost of carry'

147.95

6

,162,691.56

Forward contract value

£

US $10 m AT 1.62

6,172,839.51

No Hedge

£

U S $ 10 m AT 1.70

5,882,352.94

Evaluation of Cylinder Option From Jones Point of View

1

option premium reduced

1

sets 'best' and 'worst' outcomes if proceeds received

2

like forward contract, creates exposure if underlying proceeds not received

3

reduced premium means reduced flexibility, compared with pure option.

Available solutions