Question

Trefor, a US firm, has a sterling (£) receivable of £300,000 from a UK customer due one year from now. Trefor has no use for sterling currency and will exchange the receipt into US dollars ($). The spot exchange rate now is £1=$1.34 and the oneyear forward exchange rate is £1=$1.31. Assume the forecasted spot rate in one UL20/0419 Page 5 of 8 year’s time is £1=$1.28 or £1=$1.38, with equal probability. The discount rate is zero.

(a) What is the expected dollar value of Trefor’s receivable if it chooses:

(i) not to hedge the receipt?

(ii) to use a forward hedge?

(b) One year sterling put options and sterling call options are available at a cost of $0.03 per £ with an exercise price of £1.32.

(i) How could Trefor make use of an option hedge for its sterling receivable?

(ii) What will be the expected value in dollars of the outcome of the option hedge?

(c) If Trefor is concerned only about downside risk, is it better to choose the forward hedge or the option hedge? Explain. (60 words)

(d) An alternative hedging strategy for Trefor is to use futures contracts. Are there any advantages to using futures instead of a forward exchange extract? Explain. (60 words)

(e) Briefly discuss the implications of the Capital Asset Pricing Model for the relationship between the current spot price of an asset and the discount offered by the seller of a futures contract. (100 words)

Answer 1

£ 300,000 POUNDS RECEIVABLE

.(i) No Hedging

Expected Spot rate at the end of one year:

(0.5*$1.28+0.5*$1.38) per Pound

Or,$1.33/Pound

Expected Receipt=$(1.33*300000)= $399,000

(ii) Forward Hedge:

forward exchange rate is £1=$1.31

Receipt if forward hedge is used=$(1.31*300000)= $393,000

OPTION HEDGE

The Risk is decrease in spot rate . With decreasing spot rate dollar received will be less.

Hence PUT option to be used to hedge the risk.

BUY 300000 PUT option with strike price= $1.32/£  

Cost of Option =$0.03*300000=$9000

Expected spot rate at end of one year=$1.33/Pound

Expected Value in dollars=(1.33*300000)-$9000=$390,000

If spot rate at expiration is lower than 1.32, the loss in spot will be compensated by gain in PUT

If Trefor is concerned only about downside risk, it is better to choose the forward hedge .

Because the forward rate will give him certain amount of $393,000 which is higher than expected receipt in option hedge

(d) FUTURE CONTRACT

If future contract is used, there is possibility of unlimited gain with unlimited risk. If Trefor expects the exchange rate to go up, it should use Future Contracts