Question

Suppose an Australian importer has to make a €100,000 payment to a German exporter in 60 days. The importer could purchase a European call option to have the euros delivered to him at a specified exchange rate (the strike price) on the due date. Suppose further that the option premium is AUD0.015 per euro and the exercise price is AUD1.50. Discuss the following status/scenarios of this call option for the Australian importer:

1. If the Spot rate were to rise to AUD1.55 or fall to AUD1.45 indicate whether the option is in-the-money or out-of-the-money for each scenario and will the importer exercise or let the option lapse and why?

2. What is the cost of this option?

3. When is the importer indifferent about exercising or letting the option lapse?

4. Alternative hedging strategies are forwards and futures. How do they differ from options?

Answer 1

1. If the Spot rate were to rise to AUD1.55 or fall to AUD1.45 indicate whether the option is in-the-money or out-of-the-money for each scenario and will the importer exercise or let the option lapse and why?

If strike price is more than exercise price, call is in the money ( ITM).

If the strike price is 1.55 AUD,

Particulars	Amount
Difference between stirk price and exercise price	5000
( 100000 * ( 1.55-1.50)
Less : Option premium	1500
( 100000* 0.015)
Net Profit	3500

If strike price is 1.45 AUD, it is less than the exercise price of 1.5 AUD. Hence, call is out the money.

  

Particulars	Amount
Difference between stirk price and exercise price	(5000)
( 100000 * ( 1.45-1.50)
Less : Option premium	(1500)
( 100000* 0.015)
Net Profit	(6500)

To minimize the loss, importer should lapse the call option. His loss is equal to call option premium.i.e. 1500 AUD

2. What is the cost of this option?

Cost of call option is

100000 AUD * 0.015 ( call option premium per AUD) = 1500 AUD

3.When is the importer indifferent about exercising or letting the option lapse?

If the increase in strike price is equal to call option premium ie. 1.515 ( 1.50 + 0.015), Importer would be indifferent about exercising or letting the option lapse.

Particulars	Amount
Difference between stirk price and exercise price	1500
( 100000 * ( 1.515-1.50)
Less : Option premium	(1500)
( 100000* 0.015)
Net Profit	Nil

4.Alternative hedging strategies are forwards and futures. How do they differ from options?

Option, future and forward contracts are similar type of hedging instruments. However, they are having below mentioned key difference.

Option contracts gives buyer a right not an obligation to buy or sell a specified asset at specified price at the end of specified future date. Hence, Buyer's risk is limited up to the option premium However, option writer's risk is unlimited, as he has to honor contract, if buyer wants to do.

Future contract is a contract where buyer has an obligation to purchase specified asset at specific price and seller has an obligation to sell specified asset at specified price at the end of specified future date. Hence, both buyer's and seller's risk are unlimited. But, both future and options are standardize contracts and tradable in stock exchange.

Forward contracts are tailor made contract which specified buyers has an obligation to buy specified asset as specified price at the end of specified future date and seller has an obligation to sell specified asset at specified price at the end of specified future date. Forward contracts are tailor made and not traded in stock exchange.