Question

Question 5

Suppose an Australian importer has to make a €100,000 payment to a German exporter in 60 days. The importer could purchase a European call option to have the euros delivered to him at a specified exchange rate (the strike price) on the due date. Suppose further that the option premium is AUD0.015 per euro and the exercise price is AUD1.50. Discuss the following status/scenarios of this call option for the Australian importer:

1. If the Spot rate were to rise to AUD1.55 or fall to AUD1.45 indicate whether the option is in-the-money or out-of-the-money for each scenario and will the importer exercise or let the option lapse and why?

2. What is the cost of this option?

3. When is the importer indifferent about exercising or letting the option lapse?

4. Alternative hedging strategies are forwards and futures. How do they differ from options?

[4 + 2 + 2 + 4 = 12 marks]

Answer 1

Solution:

i)

As the importer is taking up a call option he is profited if the spot rate of the Euro is greater than the exercisable price. Hence he exercises the option contract. Hence when the spot price is 1.55 he is in the money and when the spot price is 1.45 is out of money.

ii.

As the importer has to make 100000 euroes the cost of the option is generally the premium paid to take up the option.

Hence the total option premium paid=0.015*100000=1500.

iii.

When the exercise price is equal to the spot price then the importer can exercise or lapse the contract as it makes no difference for him.

iv.

With options the investor has to pay a specified premium for the taking up of contracts and if he is in out of money, then he shall lapse the option contract and the premium paid shall be the limited loss for option holders and there can be a chance of unlimited loss fir options writers.

Whereas futures are also a agreement to buy or sell at a specified rate in future and profits depends on if the investor is in the money or out of money.

Whereas forwards are a contract between two parties to settle at a future date for a specified price irrespective of market price.

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