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Homework answers / question archive / Assume an American firm (XYZ) is expected to pay 10m GBP (£) in one year’s time
Assume an American firm (XYZ) is expected to pay 10m GBP (£) in one year’s time. If XYZ hedges its foreign exchange exposure using options, what will be its total dollar payment in one year’s time, including time value of money? Also briefly explain what XYZ needs to do at the end of one year.
Available Information:
one-year forward rate: US$1.46/£
spot rate: US$1.26/£
call option on pounds with a strike of US$1.42 has a premium of US$0.08
interest rates: US: 4.5% per annum UK: 7% per annum
Payment Exposure in Foreig Exchange after 1 year = £ 10,000,000
Under option hedging the American Firm should buy a call option at a strike price $1.42 per £.
By buying a call option the american firm will get an right to buy the £ by paying a fixed amount $1.42 per £.
Premium need to buy the call option = $0.08 per £
Total premium to be paid now = £ 10,000,000*$0.08 per £ = $800,000
Now to pay the premium , the american firm needs to Borrow $800,000@4.50% interest per annum.
Total Dollar payment under Option hedging = [ Exposure * Strike rate ] + Call option premium + Interest on call option premium
=>Total Dollar payment under Option hedging= [ £ 10,000,000*$1.42 per £] + $800,000+ [$800,000*4.50%]
=>Total Dollar payment under Option hedging= $15,036,000
At the end of the year the American firm will pay $1.42 per £ to purchase £ 10,000,000. Also the american firm will repay the loan taken to pay the call option premium along with the interest.
If at the year end or at the option maturity, if the rate per £, is less than the strike price $1.42 per £, then the American firm will not exercise the option to buy the £ 10,000,000, as per the call option. Rather American firm will buy the £ 10,000,000 from the market.
