Question

Currency Collar/Range Forward: A Canadian importer will have to PAY £1,000,000 in 3 months. The sport exchange rate for $/£ is 1.90. The importer is worried that the $ cost will increase dramatically if the £ appreciates in the future. The importer will to accept any exchange risk between $1.85/£ and $2.00/£ rates. Any movement in the exchange rates beyond those two limits is unacceptable to the importer. Design a hedging strategy using combinations of options, i.e., currency collar or range forward, for the Canadian importer.

Answer 1

The range forward contract is done to have the protection against the adverse exchange rate movements in currency/ies while capitalizing on some favorable exchange rate moves.

In a range forward contract, one must take a long and short position through two derivative contracts (Buy a Put option at lower strike and sell call option at higher strike in our case.)

Range forward contracts are more than useful because they need two positions for full risk mitigation. The cost of the long contract generally around to the cost of the contract to sell, gives a zero net cost.

As we know the importer needs to pay in pounds, so he/she would not want pound to appreciate against dollar because he/she will have to pay more if that happens. And as we see the represention in the question is '$/£' means we are bothered more about the denominator, ideally we would buy put option at lower strike so that if the exchange rate falls below the range we could use it to our advantage. Conversely, if breaks the upside range then it would mean the dollar has strengthen against the pound. So, the weakness in the pound will make it up for any losses in the option sold.

The Canadian importer would set up a range forward contract to manage the risks of payment in pounds. This would require buying a long contract on the lower bound ($1.85/£) and selling a short contract on the higher bound ($2.00/£). IF the exchange rate after 3 months (at the time of expiry) remains anywhere between the lower and the higher bound then the contract settles at the spot rate (let's assume at $1.95/£), means no exchange rate risk as the importer is fully hedged and the price remained within the range . If the exchange rate is outside of the range (let's say at $1.80/£) at expiration then the contracts are exercised. The importer would need to exercise its long contract to buy at the floor rate of $1.85/£. Conversely, if the exchange rate at expiration is $2.05/£, the company would need to exercise its short option to sell at the rate of $2.00/£