Question

1. An American insurance company issued $10 million of one-year, zero-coupon GICs (guaranteed investment contracts) denominated in Swiss francs at a rate of 5 percent. The insurance company holds no SFr-denominated assets and has neither bought nor sold francs in the foreign exchange market.

   1. What is the insurance company’s net exposure in Swiss francs?

   2. What is the insurance company’s risk exposure to foreign exchange rate fluctuations?

   3. page 770How can the insurance company use futures to hedge the risk exposure in part (b)? How can it use options to hedge?

   4. If the strike price on SFr options is $1.0425/SFr and the spot exchange rate is $1.0210/SFr, what is the intrinsic value (on expiration) of a call option on Swiss francs? What is the intrinsic value (on expiration) of a Swiss franc put option? (Note: Swiss franc futures options traded on the Chicago Mercantile Exchange are set at SFr125,000 per contract.)

   5. If the June delivery call option premium is 0.32 cent per franc and the June delivery put option is 10.7 cents per franc, what is the dollar premium cost per contract? Assume that today’s date is April 15.

   6. Why is the call option premium lower than the put option premium?

Answer 1

Answer to Question No 1:

The net exposure of the Insurance Company to the Swiss Frances is given by

Net Exposure of the insurance company in Swiss Francs= (Assets denominated in Swiss Francs-Liabilities Denominated in Swiss Francs)+(Swiss Francs Bought-Swiss Francs Sold)

As given in the question:The company has not brought or sold Swiss Francs and neither owns any assets in Swiss Francs.However it has a liabilities of $ 10 million denominated in Swiss Francs.

So,substituting these values into the formula for net exposure for the insurance company, we get:

Net Exposure to the insurance company in Swiss Francs= (0-$10 millions)+(0-0) ie. -$ 10 millions.

Answer to Question No 2:

The insurance company has liabilities in Swiss Francs.In other words it is holding a short(seller) position in Swiss Francs .Hence the company is exposed to the risk of appreciation of Swiss Francs.An appreciation in Swiss Francs means that the value of Swiss Francs will increase as compared to USA dollar (in this case).This means that at maturity the company will have to pay more Swiss Francs in exchange for USA Dollars.

Hence, the insurance company will face risk from appreciation in Swiss Francs.

Answer to Question No: 3(a):

The insurance company can hedge this exposure by going long (ie. buying) Swiss Franc Futures.This will enable them to buy the Swiss Francs at a lower rate and cover the losses incurred by selling the Swiss Francs at a higher rate.

A Currency Futures is a derivatives contract that gives the price at which in terms of one currency(in our case USD ) at which another currency can be either brought or sold .

A long position in a Currency Futures means that the future contract holder(in our case) will but the foreign currency(in our case Swiss Francs) at a price specified today.

Answer to Question No: 3(b):

The insurance company can also hedge their exposure by taking along position(buying) Swiss Francs Call Option.

A Currency Call Option refers to a call option which gives the holder(buyer or long position holder) of a call option the right but not the obligation to buy the underlying asset(ie :  one currency in terms of another currency) at a price specified today.

The advantage of using options over future contract is that in case of futures contract , if the value of Swiss Francs is declining (ie. decreasing) then the company will incurr a large loss(unlimited) on the futures contract on the other hand for an option buyer the loss is limited to the extent of the premium paid.(the price paid by the company to the option seller at the time of entering the options contract)

Answer to Question Number (4)(a):

Intrinsic Value of a Call Option=Underlying Price(Current)-Strike Price

Here, the Underlying Price(Current) of Swiss Francs= $ 1.0210

Strike Price= $ 1.0425

Putting these values into the above formula we get:

Intrinsic Value of a Call Option= $1.0210-$1.0425 ie. -$0.0215 ie. 0(Intrinsic Value is always positive.Negative Intrinsic value is taken as zero).

Answer to Question No: 4(b):

Intrinsic Value of a Put Option=Strike Price-Underlying Price(Current)-

Here, the Underlying Price(Current) of Swiss Francs= $ 1.0210

Strike Price= $ 1.0425

Putting these values into the above formula we get:

Intrinsic Value of a Call Option= $1.0425-$1.0210 ie. $ 0.0215

Again the option contract size as given in the question is SFr: 125,000

So, Total Intrinsic Value= Intrinsic Value per option contract*Contract Size ie. $0.0215*125,000 ie. $2687.50

Answer to Question Number 5(a)& (B):

Dollar Premium Cost Per Contract= Premium Per Franc*Contract Size

Here Premium Per Franc=0.32 cents or .032(call option), 10.7 cents or .107(put option)(Dividing 0.32 and 10.7 with 100 inorder to convert to dolalrs)

Contract Size= SFr 125,000

So, substituting these values into the formula we get:

Dollar Premium Cost Per Contract= .032*125,000, .107*125,000 ie. $400(Call Option) and $13,375(Put Option)

Answer to Question Number 6:

The pt option premium is higher than the call option premium as the put option is in -the-money( an in-the-money put option is an option contract whose strike price is higher than the underlying asset price) and call option is not.