Question

Question 8 Assume that Epping Co. expects to receive S$500,000 in one year. Epping created a probability distribution for the future spot rate in one year as follows: Future Spot Rate $.68 .62 Probability 20% 50 30 .61 Assume that one-year put options on Singapore dollars are available, with an exercise price of $0.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Use the appropriate options hedge to determine whether the firm would exercise the option using each of the three different spot rates i.e. what would the firm do if each spot rate existed at the time it is considering exercising the option (assume the option is about to expire). Then, show the total amount of receivables (in US dollars) based on the appropriate strategy that would be implemented for each of the three spot rates. Indicate whether the amount would be a maximum or a minimum or neither. 10 points C

Answer 1

A. Put option
FSP	Strike price	E/L	In flow	Premium	Net inflow	Prob.	Expected in flow
0.68	0.63	Lapse	0.68	0.04	0.64	0.2	0.128
0.62	0.63	Exercise	0.63	0.04	0.59	0.5	0.295
0.61	0.63	Exercise	0.63	0.04	0.59	0.3	0.177
				Expected rate per $ =			0.6
Expected inflow after one year = S$ 500,000 * $0.6
		=	$300,000
B. Call Option
FSP	Strike price	E/L	Outflow	Premium	Net outflow	Prob.	Expected outflow
0.68	0.60	Exercise	0.60	0.03	0.57	0.2	0.114
0.62	0.60	Exercise	0.60	0.03	0.57	0.5	0.285
0.61	0.60	Exercise	0.60	0.03	0.57	0.3	0.171
				Expected rate per $ =			0.57
Expected Outflow after one year = S$ 500,000 * $0.57
		=	$285,000
From above it is observed that the benefit is higher if put option is taken upon.