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In: Finance

Our company has just made a bid today, July 11, 2018, for a service contract in...

Our company has just made a bid today, July 11, 2018, for a service contract in Sweden. Unfortunately, the bid had to be in kronas. The current exchange rate is 8.4 SEK/USD. We will find out by September 10, 2019 whether we won the contract or not. The size of the bid is $10 Million kronas payable on October 1, 2019. The service will be delivered from October 1, 2019 through September 30, 2020. To protect ourselves against exchange rate fluctuations, we buy a European put option with an exercise price of 5.0 SEK/USD on the krona in Philadelphia Exchange for 10 Million kronas with an exercise date October 1, 2019.
Is this an appropriate strategy for us? Explain fully.

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Expert Solution

European Put buy is bought is to protect any kind of unfavorable movement in the exchange rate. In this case, the company is expecting the payment of $10 million Kronas by October 1, 2019. On October 1, 2019, the company, if they win the contract, needs to exchange the $10 million Kronas. Current exchange rate is 8.4SEK/USD and if the exchange rate goes up to say 10 SEK/USD then company will be receiving few dollars for exchanging the number of Kronas as Kronas has appreciated.

Hence the decision of buying an European Put option at 5 SEK/USD is most appropriate. In case the company wins the contract and exchange rate has appreciated then company can exercise put option . In case, if the exchange rate falls below 5 SEK/USD, then company will not exercise put and will lose only the premium amount. Also in case if the company fails to win the contract then also the company lose only the premium amount paid for options.

Hence in this gain, the amount of loss is limited to the amount of premium paid but the exchange rate risk is hedged in appropriate manner.

jeff jeffy answered 2 years ago
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