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A U.S. company will receive payments of £1.25 million next month. It wants to protect these...

A U.S. company will receive payments of £1.25 million next month. It wants to protect these receipts against a drop in the value of the pound. It can use 30-day futures at a price of $1.6513 per pound or it can use a call (put) option with a strike price of $1.6612 at a premium of 1 cent (2 cents) per pound. The spot price of the pound is currently $1.6560., and the pound is expected to trade in the range of $1.6250 to $1.7010. How can the company use future or option hedge its risk? How many futures contracts will the company need to protect its receipts? How many options contracts? Diagram the company’s profit and loss associated with the option position and future position within the range of expected exchange rates. Ignore the transaction costs and margins. Show the total cash flow to the company using the options and futures contracts, as well as the unhedged position within range of expected future exchange rates. What is the break-even future spot price on the option contract? On the futures contract?

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Expert Solution

Payment to be received next month : 1.25 million pounds

Spot price of pound = $1.6560

Future price of pound = $1.6513

Call(put) option with a strike price of $1.6612 per pound = 1 cents(2 cents)

A. Usage of future contract to hedge the risk:

Tentative range for price of pound in future is from  $1.6250 to $1.7010 , if company believes that price of pound is going to decrease and become less than $ 1.6513 , then in that case it should purchase future contract to hedge the full position of 1.25 million pounds.

Other wise company should not go with the future contract and rather go with an option

B. Usage of call option with a future contract to hedge the risk:

If company believes that value of pounds is going to decrease and  will not cross $1.6612 , then it can sell call option to earn premium of 1 cents per dollar and also buy a futures contract at $1.6513 so that it can earn $1.6513+$.01 = $1.6613

C. Usage of put option with a future contract to hedge the risk:

If company believes price of pound is going to increase in future but still wants to protect the downside then company can purchase a put option and minimize its exchange rate to $1.6612- .02 = $1.6412 and unlimited up potential

Graph for purchase of call option, future contract , put option is given as follows :

jeff jeffy answered 1 year ago
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