In: Accounting
You are the treasurer of Montana Corp. and must decide how to hedge (if at all) future payables of 1 million Japanese yen 90 days from now. Call options are available with a premium of $.0004 per unit and an exercise price of $.01040 per Japanese yen. The forecasted spot rate of the Japanese yen in 90 days is $0.01043 with probability 30%, $0.01042 with probability 25%, $0.01039 with probability 25%, and $0.01038 with probability 20%. What is the probability that the call option will be exercised? What is the estimated dollar cash outflows of currency call hedge? 45%; $10,414 55%; $10,793.5 55%; $10,393.5 45%; $10,814
Answer to the question is as follows :
1. Amount Payable in JP Yen = 1,000,000 JPY
2. Amount Payable in US Dollar @ $0.0104 / Yen = 1,000,000 x 0.0104 = $ 10,400 3 months from now.
3. Call Option Premium = $ 0.0004 p.u. = $ 1,000,000 x 0.0004 = $ 400 for the entire contract
4. As per table following 4 scenarios arise :
Scenario | Forecasted Spot Rate | Probabilty | Strike Price | Payoff [Higher of (Spot - Strike), 0 ] | Option Value |
1 | 0.01043 | 30% | 0.01040 | 0.00003 | In the money |
2 | 0.01042 | 25% | 0.01040 | 0.00002 | In the money |
3 | 0.01039 | 25% | 0.01040 | - | Out of the Money |
4 | 0.01038 | 20% | 0.01040 | - | Out of the Money |
Hence Probability that call option will be exercised is when it is In the money = 30% + 25% = 55% (Scenario 1 Probability + Scenario 2 Probabilty].
5. Estimated Dollar Cash Outflows of Currency Call Hedge =
Scenario | Forecasted Spot Rate | Probabilty | Strike Price | Payoff [Higher of (Spot - Strike), 0 ] | Dollar Payoff received |
1 | 0.01043 | 30% | 0.0104 | 0.00003 | $ 3,129.00 |
2 | 0.01042 | 25% | 0.0104 | 0.00002 | $ 2,605.00 |
3 | 0.01039 | 25% | 0.0104 | - | $ 2,600.00 |
4 | 0.01038 | 20% | 0.0104 | - | $ 2,080.00 |
Total = | $ 10,414.00 |