Question

1. OTC agrees to buy an equipment for € 2,500,000. The purchase will be made in June 1^st with payment due six months later in December 1^st. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, OTc is considering to use either options or future to hedge the payment. (25 points, 5 points each)

To help the firm make a hedging decision you have gathered the following information:

The spot exchange rate is $1.0981/€.

December 1^st call option for $1.1481/€ for a premium of 1%.

December 1^st call option for $1.1258/€ for a premium of 1.5%.

OTC’s cost of capital is 12% per year.

1. What is best choice between these two options? How much will OTC pay in the worst case situation in December 1^st?

2. If December 1^st put option for $1.0889/€ for a premium of 1% and December 1^st put option for $1.0932/€ for a premium of 1.5%. Will you change your answer for part a? If so, what will be OTC’s situation in December 1^st?

3. If the exchange rate in December 1^st is $1.1198/€, assume OTC follows your recommendation for part b, how much will OTC pay?

4. The December future contract has future price $1.1208/€ when the contract is signed, and the future will expire in 6 months at Dec 1^st. Each future contract for EURO has €125,000 underline, and the initial margin is $2,565. Assume everything happens when the future expires. The spot exchange rate at future expiration is $1.1198/€. We ignore all daily cash settlements during the 6 months, how much will OTC receive or pay in aggregate for future contracts? How much will OTC cost for this payable with future contract?

5. If the future contract will be expired at the end of December, and the future price at December 1^st is 1.1250/€. The spot exchange rate at future expiration is $1.1198/€. We ignore all daily cash settlements during the 6 months, how much will OTC receive or pay in aggregate for future contracts? How much will OTC cost for this payable with future contract?

Answer 1

a) the best choice will be December 1st call option for 1.1258 at premium of 1.5%.

Because higher the premium, better the scope to earn profit.

b) if the premium goes down to 1% then the later option will give maximum return.

C) if exchange rate is 1.1198, the OTC will be = 25,00,000*1.1198/500000 =$ 11.56

d) the December future contract will be 125000 as per the OTC rate. I.e. 750000/5=125000

e) if price goes down, then the OTC will be coming down. As a result, OTC will be 125000/5000=$25