Question

You plan to visit one of your friends living in Colorado, America in three months. You expect to incur the total cost of US$20,000 for lodging, meals, and transportation during your stay. As of today, the spot exchange rate is RM_____/ US$ and the three-month forward rate is RM_____/ US$ (please refer to Table 1 below for your given rates). You can buy the three-month call option on US$ with the exercise rate of RM4.3/ US$ for the premium of RM1 per US$. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 3.2 percent per annum in Malaysia and 2 percent per annum in the United States.

1. Calculate your expected ringgit cost of buying US$20,000 if you choose to hedge via call option on US$.

2. Calculate the future ringgit cost of meeting this US$ obligation if you decide to hedge using a forward contract.

3. At what future spot exchange rate will you be indifferent between the forward and option market hedges?

4. Illustrate the future ringgit costs of meeting the US$ payable against the future spot exchange rate under both the options and forward market hedges.

TABLE1

S(RM/USD)	F3m(RM/USD)
4.195	4.245

Answer 1

Alternative 1.

Forward cover

Calculation of future ringgit cost of meeting of obligation:- 20000US $ * 4.245 = 84900 RM

As question has given us rate of per us dollar so we will multiply it. Base rate is in foreign currency.

In this case if forward rate turns into future spot rate then there will be no gain or loose.

If expected future rate is 4 245 and as well as it is forward rate too. So there is no gain or loose.

Alternative 2.

Option cover

In option cover excercise rate ( E) is : 1US$=4.3RM

And expected future spot rate is 1US$=4.245RM so here in call option it is lower than E so option will get lapsed. And rate of buying in case of option cover will be 1US$= 4.245RM.

Additionally we will pay intial premium for this 1RM=1US$ that means 20000RM we will pay extra that will be upfront so interest on premium and premium cost we will pay extra in case of option cover.

Cost will be in case of option cover:- 4.245 + 1 for premium= 5.245 RM * 20000 = 104900 RM

Additionally interest on premium 20000*3.2%*3/12=160 RM so total cost in case of option 105060

Forward cover is the best alternative for risk hedge.