ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Options - calculations - Notes ^{11 / 13}

If the movement in the exchange rate is favourable
- don't exercise the option
- let it lapse
If the movement is adverse
- exercise the option

Do I want call or put options?
Will I buy (call options) or sell (put options) the BASE currency?
Choose expiry
Choose strike (exercise) price
How many contracts?
How much BASE currency do I receive (call options)/pay (put options)?
Calculate Premium
Amount not hedged
Choose whether to exercise

Kenduri Co is based in the UK. It will have to pay $2,400,000 in 3 months.

Spot rate US$/£1:
1.5938-1.5962

Hedging using Forward: £1,500,375 payment

Required

Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$ cash flows it is due to pay in three month.

Currency options available to Kenduri Co

Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1

Exercise	Call options 3-month expiry	Call options 6-month expiry	Put options 3-month expiry	Put options 6-month expiry
1.60	1.55	2.25	2.08	2.23

Do I want call or put options?
BASE currency is £.
Kenduri Co will pay $2.4m in 3 months, therefore have to sell £ to buy $2.4m, therefore Kenduri Co would purchase Sterling three-month put options to protect itself against a strengthening US$ to £.
Choose expiry
Kenduri Co will choose Put 3-month expiry options, because it will pay $2.4m in 3 months.
Choose strike (exercise) price
Exercise price: $1•60/£1
£ payment = 2,400,000/1•60 = £1,500,000
How many contracts?
£1,500,000 / £62,500 = 24 contracts
24 put options purchased
How much BASE currency do I pay (put options)?
£ payment = 2,400,000/1•60 = 1,500,000
Calculate Premium
Premium payable = 24 x 0•0208 x 62,500 = US$31,200
Premium in £ = 31,200/1•5938 = £19,576
Note:
Kenduri Co will pay the premium in US$31,200. Kenduri Co have to buy $ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1.5938 is used.
Amount not hedged
All amount is hedged (refer to step 4)
Choose whether to exercise
Total payments = £1,500,000 + £19,576 = £1,519,576
£1,519,576 > £1,500,375 FWD, therefore use the Forward rate hedge.

Casasophia Co, based in a European country that uses the Euro (€) is due to receive the final payment of US$20 million in four months.

Spot rate $ Per €1:
US$1·3585–US$1·3618

4-month forward $ Per €1:
US$1·3588–US$1·3623

Hedging using Forward contracts is €14,681,054.

Required

Advise Casasophia Co on, and recommend, an appropriate hedging strategy.

Exercise price	Calls 2-month expiry	Calls 5-month expiry	Puts 2-month expiry	Puts 5-month expiry
1.36	2.35	2.80	2.47	2.98

Do I want call or put options?
BASE currency is EUR.
Casasophia Co will receive $20m in 4 months and then will convert them to EUR (buy EUR), therefore Casasophia Co would purchase Euro call options to protect itself against a weakening Dollar to the Euro.
Choose expiry
Casasophia Co will choose Call 5-month expiry options, because it will receive $20m in 4 months. The 2-month expiry is too short.
Choose strike (exercise) price
Exercise Price: $1•36/€1
€ receipts =$ 20,000,000/($1•36/€1) = €14,705,882
How many contracts?
€14,705,882 / €125,000 = 117•6 contracts
117 call options purchased
How much BASE currency do I receive?
€ receipts = 117 x €125,000 = €14,625,000
Calculate Premium
Premium payable = 117 x 0•0280 x 125,000 = US$409,500
Premium in € = 409,500/1•3585 = €301,435
Note:
Casasophia Co will pay the premium in US$409,500. Casasophia Co have to buy $ from the bank (the bank will "sell LOW" $, therefore the Spot rate US$1·3585 is used.
Amount not hedged
Amount not hedged = US$20,000,000 – (117 x €125,000 x 1•36) = US$110,000
Use forwards to hedge amount not hedged = US$110,000/1•3623 (the banks "buy high")= €80,746
Choose whether to exercise
Total receipts = 14,625,000 Receipt– 301,435 Premium + 80,746 FWD = €14,404,311
€14,404,311 < €14,681,054 FWD contract, therefore choose badge using the forward contract.