In: Finance
1) You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.
Information for Forward Contract:
Forward exchange rate (one yr): 1.54 $/BP
Information for Money Market Instruments (MMI):
Current exchange rate: 1.50 $/BP
Investment return at Aerion Fund Management (in UK): 4% annual
Interest rate of borrowing from Bank of America (in USA): 2% annual
Information you need for Currency Options Contract:
Options premium: 0.015 $/BP
Interest rate of borrowing from Bank of America (USA): 2% annual
Allowed to exercise options at 1.54 $/BP
What are the costs of MMI? (Answer in US$ of course. You are US company!)
2) You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.
Information for Forward Contract:
Forward exchange rate (one yr): 1.54 $/BP
Information for Money Market Instruments (MMI):
Current exchange rate: 1.50 $/BP
Investment return at Aerion Fund Management (in UK): 4% annual
Interest rate of borrowing from Bank of America (in USA): 2% annual
Information you need for Currency Options Contract:
Options premium: 0.015 $/BP
Interest rate of borrowing from Bank of America (USA): 2% annual
Allowed to exercise options at 1.54 $/BP
If the break-even exchange rate for the Currency Options Contract is 1.46 $/BP, and you believe the exchange rate at the time of the payment would be 1.43 $/BP, should you sign the contract?
1)
Borrow Us dollars from Bank of America equivalent to 500,000 BP at current exchange rate of 1.50 $/BP = 500,000* 1.50 = $ 750,000 at 2% per anum interest rate.
1 Year interest to be paid to Bank of America along with principal amount of USD 750,000 would be = 750,000 * 2% = $15,000
Convert USD 750,000 to BP 500,000 and invest with Aerion Fund Management (UK) at 4% per anum interest rate for 1 year.
1 Year investment return would be = 500000 * 4% = BP 20,000
After 1 Year, realize the investment in BP on its maturity and US company will get BP 520,000 in UK.
Out of this, make payment of BP 500,000 and convert remaining BP 20,000 at forward exchange rate given of 1.54 $/BP = 20,000 * 1.54 = $ 30,800.
With this $ 30,800, US company will pay back its interest obligation of $15,000 to Bank of America and remaining $15,800 (i.e. 30,800 - 15,000) is the gain to the US company and after deducting the gain from principal obligation of USD 750,000, remaining Principal of USD 734,200 (i.e. 750,000 - 15,800) will be paid by the US company from their sources of funds as the company was liable to repay the amount in 1 year anyway. With MMI, US company could gain some amount by investing in UK 1 year prior to the actual due date.
2)
No, we will not sign the contract because the break-even exchange rate itself is 1.46 $/BP and it would mean that exchange rate below this price will give gains to the company and above this price would be a losing proposition. Since on the due date, exchange rate in the market will be lower than the options break-even price, company will buy the BP from the market and pay its obligation instead of exercising option at higher rate.
I hope above answer will help in your task.