Question

You are UK company, 200,000 US$ payable to US in one year. Answer in terms of BP (British Pound). Round at four decimal places Examples: 1.23487 ---> 1.2349; 1.23533 --> 1.2353 Information for Forward Contract: Forward exchange rate (one yr): 0.7124 BP/$ Information for Money Market Instruments (MMI): Current exchange rate: 0.7173 BP/$ Investment return at JP Morgan (in US): 5% annual Interest rate of borrowing from HSBC (UK): 3% annual Information you need for Currency Options Contract: Exercise options premium at 0.09 BP/$ Interest rate of borrowing from HSBC (UK): 3% annual Allowed to exercise options at 0.7215 BP/$ Under the COC, the break-even exchange rate is .6109 BP/$. If the management team speculates the exchange rate at the time of the payment would be .6223 BP/$, would they sign the COC contract in this case? No Yes

Answer 1

Case:If the management team speculates the exchange rate at the time of the payment would be .6223 BP/$, should they sign the COC contract in this case, The answer is NO.

If the exchange rate after one year is 0.6223 BP/$
If this speculation holds true then an unhedged transaction would be most beneficial
Exchange Rate 1 USD = BP 0.6223
Cost of USD 200,000 (unhedged) = BP 124,460

Alternatively, let’s calculate price of Currency option which if currency rate is .6223 BP/$ at expiry

a.Premium Paid on USD 200,000 option = BP18,000 (200,000*0.09)
b.Interest cost on premium (18000* 3%) = BP 540
c.Net cost on premium of option = BP 18,540

d.Call option exercise Price (K) = 0.7215 BP/$
e.Expected Currency Price at Expiry (S) = 0.6223 BP/$
f.Price of Call Option at expiry = MAX[0,(S-K)]

= MAX[0,(0.6223-07215)] = max[0, -0.0992]
=0
g.If the strike price of the call options is lower than the exercise price, the call option doesn’t exercise. And hence the USD will be bought at the spot price at expiry (i.e 0.6223)
0.6223 BP/$ * USD200,000 = BP 124460
h. NET Cost incurred if COC contract entered (c+g) = BP 124460 +540= BP 143,000


Let's consider the other options

Option 1 Cost of Forward Contract BP 142,480
1 year Forward Exchange Contract 1 USD = BP 0.7124
Cost to buy USD 200,000 ( 200,000 * 0.7124) = BP 142,480

Option 2 Cost of Money Market Hedge BP 140,727.43​​​​​​​

Step 1, Ascertain amount of USD required

Interest rate in USA 5%
Amt required at the end of 1 year USD200,000
amount to be invested now so that maturity amount is USD 200,000 in one year = USD 200,000/(1+5%)  = $190,476.19

Step 2 Borrow in BP and buy $ 190,476.19 in spot market

a.Current Spot Rate: 1 USD = BP 0.7173
b.Cost of Buying USD 200,000 = BP 136,628.57
c.Interest Rate in UK =    3%
d. Cost of Borrowing (BP 136,628.57* 3%) = BP 4,098.86
e.Cost of money Market Hedge (b+d) = BP 140,727.43​​​​​​​