Question

In: Finance

Q4. A) How exchange rate risk is managed by an MNC? B) Mr. Ali has bought...

Q4. A) How exchange rate risk is managed by an MNC?

B) Mr. Ali has bought a Call option whereby volume of the currency to be exchanged is USD100,000 executeable in one week and the exercise price is PKR 165/USD1. As, he has imported some goods and is about to pay to USA exporter. Current prevalent spot rate is PKR153/1USD. Mr Ali has paid a call premium of USD50. After one week:

Case 1: The exchange rate of PKR has appreciated by 10%

Case 2: The exchange rate of PKR has depreciated by 8%
  1. In which case will Mr. Ali exercise the option?

Find the gain or loss on the option in both cases for buyer and seller of option?

Solutions

Expert Solution

Part a)

By entering into hedging contract, exchange risk is managed by an MNC. Hedging contracts are forward contract, option & Money market.

Part bi)

Case 1: Exchange rate of PKR after one week appreciated by 10%

Current spot rate PKR 153 = USD 1

After one week PKR 153 = USD1.1

USD1 = PKR 153/1.1 = PKR 139.09

Case 2: Exchange rate of PKR after one week depreciated by 8%

Current spot rate PKR 153 = USD 1

After one week PKR 153*1.08 = USD1

PKR 165.24 = USD 1

Decision:

Case PKR Exercise price Actual rate Exercise/Lapse Reason
1 Appreciated by 10% PKR 165/USD1 PKR 139.09/USD 1 Lapse Actual rate is less than exercise price
2 Depreciated by 8% PKR 165/USD1 PKR 165.24/USD 1 Exercise Exercise price is than actual rate

Part bii)

Under case 1 option is allowed to lapse by the buyer.

Loss to buyer = Premium on call option = $50 = PKR 153*$50 = PKR 7,650

Gain to Seller = Premium on call option = $50 = PKR 153*$50 = PKR 7,650

Under case 2 call option is exercised by the buyer.

Net gain to buyer = (Actual price-exercise price)*$100,000 - Premium on call option

= (PKR 165.24-PKR 165)*$100,000 - PKR 7,650

= (PKR 0.24*$100,000) - PKR 7,650

= PKR 24,000 - PKR 7,650 = PKR 16,350

Net loss to seller = (Actual price-exercise price)*$100,000 - Premium on call option

= (PKR 165.24-PKR 165)*$100,000 - PKR 7,650

= (PKR 0.24*$100,000) - PKR 7,650

= PKR 24,000 - PKR 7,650 = PKR 16,350

jeff jeffy answered 1 year ago
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