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 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

a1.

Expected rate after one year time =

£1= ($1.28*0.50) +( $1.38 *0.50) = $1.33

Expected $ value to be received after 1 year if not hedged,

=>£ receivable after one year * Expected exchange rate

=> £300000* $1.33/ £1 = $399000

a2.

If forward hedginh has been done, then

Expected $ amount to be recived =

=>£ receivable after one year * Forward rate

=>£300000* $1.31/ £1 = $393000

b1.

Trefor can buy a sterling put option for £300000(Means right to sell £300000 ) at Exercise price of £1=$1.32 by paying premium of $ 0.03 per £1.

b2.

$ Amount to be received	=£300000* $1.32/£ =$396000
Less-Premium paid	=£300000 * $0.03 =$9000
Net $ RECEIPT	$387000

c.

If Trefor is concerned only about downside risk, is it better to choose the OPTION HEDGE. As if any downfall below  £1.32 the difference from 1.32 will be compensate by the put option.

-To hedge the down side risk it is better to enter into Protective put strategy strategy against £300000.

-Current Put option exercise perice is £1=$1.32 and option premium is $0.03 per £1.

-Buying the put option means Trefor is buying the right to sell £300000 @$1.32 per pound after 1 year by paying the premium.

- After 1 year what ever the price may be decreases, Trefor will receive $1.32 per £1.

-If the exchange rate is more than $1.32 per pound then Trefor can also choose not to exercise his option.

Hence Option Hedge is better.

d.

Advantages of using futures contract over forward contract hedging-

1.Futures are traded on exchanges while forwards are privately negotiated.

2.In futures contract, there are no counter party risk as the payment is being guaranteed by the stock exchange clearing houses. But in forward contract there are counter party risks involved.

3.Futures are actively traded in the exchange, but forwards are not.

4. Futures market are well regulated by the stock exchange authorities. But forwards are not regulated.

5. Futures are traded in standardized units.

e.

CAPM Calculates the Expected return on an investor from the stock

According to CAPM

ER= Rf +B(Rf-ERm)

ER= Expected return from the stock

Rf= Risk free return

B = Beta of the stock

ERm= Expected returm from the market

Futures price of an asset depends upon its expected return.

F = S (1+R)

F= futures price

S = Spot price

R = expected return from the stock.