Question

To practice for the hedging alternatives:

You plan to visit Geneva, Switzerland in three months to attend an international business conference.
You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF.
Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

Answer 1

I have answered the question below

Please up vote for the same and thanks!!!

Do reach out in the comments for any queries

Answer:

Solution (a) Expected dollar cost of buying SF 5,000 using call option Call premium is $0.05/SF, exercise price is $0.64/SF and future spot rate is $0.63/SF. Call option gives right to buy to the buyer of the call option. As the spot rate is less than the exercise price. Therefore, Investor will buy from spot market and won't exercise the call option, he only pays the premium for the call option. Calculate the premium cost as follows: (Call premium x Number of units) Total premium cost = *(1+3months interest rate) = (0.05x5,000)x(1+0,06 = (0.05x5,000)x{1+0.06) = 250x1.015 = S253.75

Calculate the total dollar cost as follows: Total dollar cost Exchage rate x Number of units + Call premium cost -0.63 x 5,000+ $253.75 = $3,150+ $253.75 = $3,403.75 Therefore, the total dollar cost of buying SF5,000 using call option is $3,403.75

Solution (b) Future dollar cost of buying SF 5,000 using forward option Forward rate is $0.63/SF. Calculate the total dollar cost as follows: Total dollar cost Forward rate x Number of units = 0.63 x 5,000 = $3,150 Therefore, the total dollar cost of buying SF5,000 using forward contract is $3,150

Solution (c) Indifferent point in future spot exchange rate in forward and option market hedges When the total dollar cost of using call option and the forward contract option is same, then the investor would be indifferent using any option. Calculate the future rate as follows at which investor would be indifferent: (Dollar cost of exchange Dollar cost of exchange in call option in forward contract + Call premium $3,150 = 5,000 > Future rate + $253.75 Future rate - $3,150 - $253.75 5,000 $2,896.25 5,000 = 50.579/ SF Therefore, if the future spot exchange rate is $0.579/ SF between call option and forward contract. Investor would be indifferent

Solution (d) If the future exchange rate goes beyond $0.64/SF then the investor will exercise call option which would be beneficial to him as exercise price would be $0.64/SF lesser than the future rate. Total cost of hedging through call option is $3,453.75 = ($3,200 + $253.75) $ Cost $3,453.75 Options hedge $3,150 Forward hedge $253.75 $/SF 0.579 0.64 (strike price)