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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$1.43/£
- spot rate: US$1.29/£
- call option on pounds with a strike of US$1.41 has a premium of US$0.07
- interest rates:
US: 4.5% per annum UK: 8% per annum
Expert Solution
Currency Options : If company use to hedge its GBP payment using option then call option will be require.
on due date maximum cost will be
Maximum Payment using call option 10m * 1.41 = $14.1 Million
Option Premium 10m * 0.07 = $0.7 Million
Total cost = $14.8 Million
The above cost is maximum cost which we have to pay including time value of money. We should also consider interest cost on premium paid (0.7 * 4.5% = $0.0315 Million.
On due date if spot price is higher than 1.41 then we will exercise call option to receive excess part and buy the GBP for payment.
If spot price is less than 1.41 then option will be lapse and we will buy GBP for payment, In this case our cost may reduce by the difference amount.
Company can also use other option of hedging through forward contract or money market hedge.
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