Question

A U.S. Company expects to receive 100 million Russian Ruble 3 months from now. A call and put on Russian Ruble are available with a strike price of RR60/$ for each option, and a premium of 1.5% for the call option and a premium of 2% for the put option. The weighted average cost of capital (WACC) for the U.S. Company is 10% and the current spot rate is RR59/$.

a) If the company hedges in the option market, which option will it choose and what is the cost of option hedge today and at maturity in U.S. Dollars? Explain your answer very well (5 points).

b) If the spot rate at maturity is RR65/$, how much would the company receive (net) in 3 months from the option hedge? (5 points)

Answer 1

a) As the US company expects to receive 100 million Ruble in 3 months from now, the company has to buy the put option to hedge the risk.

Exchange rate = RR60/$ or $0.01667/RR

Premium = $0.01667 / RR* 2% = $0.000333/RR

The premium is payable today i.e. there is an upfront cost to buy the put options. Therefore, the cost of options hedge can be taken either at the time of hedge or at the time of maturity.

So, for 100 million Ruble, cost of option hedge today = $0.000333/RR* 100 million RR = $33,333.33

Cost of option hedge at maturity = $33333.33 * (1+0.1* 3/12) = $34166.67

b) As the exchange rate is RR65/$ after 3 months, the put options to sell Ruble at RR60/$ will be exercised and the amount received by the company = 100 million RR/ RR60/$ = $1,666,666.67

However, net amount received by the company 3 months after the options hedge (i.e. when the 100 million RR is received) = $1666666.67- $34166.67 = $1632500