Question

A US company X purchased goods from a Belgium based company worth 800 million Euro. Company X buys a ‘relevant’ option at 1 Euro = 1.33 USD in 2 months time. X pays an option premium of 0.001 USD per Euro.

a) What relevant option X will purchase to hedge its currency

b) What is the strike price?

c) How much is the option premium paid for this contract?

d) Under what circumstance would you exercise the option?

e) What is the break-even price?

f) How much profit does X make if the spot rate per Euro after 2 months is 1.30USD?

Answer 1

A US company X purchased goods from a Belgium based company worth 800 million Euro. Company X buys a ‘relevant’ option at 1 Euro = 1.33 USD in 2 months time. X pays an option premium of 0.001 USD per Euro.

a) So basically the US company has to make a pyament in EUR and is worried that if EUR appreciates it will have to shell out more USD for buying the same number of EUR. Therefore it will buy a call option on EUR which will fix the price at which it can buy the EUR in USD terms and then make the relevant payment using the same EUR. This option is similar to buying a put option on the USD for a strike price in EUR in exchange of a given numebr of EUR. But as the quote gives 1 unit of EUR so we will have to take the relevant option on the EUR which is the Call option.

b) Strike price is USD 1.33 for every 1 unit of EUR.

c) Total option premium is calculated as follows:

Required amount of EUR	800	million
Premium per EUR	$0.001
Total premium paid	0.80	million

Therefore the premium paid is $0.8 million or USD800,000

d) If the price of EUR increases beyond the strike price, that is USD 1.33 per ERU then only is it profitable to exercise the option because then the company can buy the EUR cheaper by exercising the option than from the market while if the price falls, then it is cheaper to buy from the market.

e) Breakeven price is when there is not profit after adjusting for premium, so we can calculate the same as follows:

So the breakeven price is USD 1.331 per 1 unit of EUR

f) If the spot price is USD1.30 then the option will not be exercised and the premium paid will be lost so the loss will USD 0.8 million or USD800,000