Assume the spot rate of the £ is $1.7000. The British interest rte is 10%, and t
ID: 2619944 • Letter: A
Question
Assume the spot rate of the £ is $1.7000. The British interest rte is 10%, and the US. interest rate is 11% over the 3 the US. inflation rate is 3.5% over the 360-day (1 year) period. The 180-day forward price is $1.7200/. The 180-day European call option on the S with the exercise price of £0.5800 is selling at 3% premium, while the 180-day European put option on the $ with the exercise price of £0.5900 is selling at 2% premium. Your US, based firm has an account payable of £200,000 due in 180 days. 60-day (1 year) period. The British inflation rate is 4% and A) What should be the 180-day forward rate based on Interest Rate Parity (IRP)? + What is the dollar cost of using a forward hedge? Make sure you state your position (4 marks) + B) Assume the firm has no excess cash. Use the above to calculate the dollar cost of in the forward contract. using a money market hedge to hedge £200,000 of payable due in 180 days? (6 marks)w C) Calculate the cost of an option hedge at the time the payment is due assuming yoru (6 marks) exercise the option when the payment is due D) Based on the answers in (a), (b), and (c), which hedging methods should your firm (4 marks) choose?Explanation / Answer
A. As per the interest rate parity, the 180 day forward rate should = Spot Rate * (1+rUSD)/(1+rGBP) where r is the respective interest rate of US and UK. Hence we get Forward rate F180 = 1.70 * (1+11%/2) / (1+10%/2) = $1.7081/GBP
Since the firm has a payable of GBP 200,000 in 180 days, the dollar cost of hedge through forward rate will be = (1.72 * 200000) = $ 344,000
B. For the money market hedge, the steps will be as below:
C. Since the company has payable in GBP, it is hedging for appreciation in GBP hence they will buy call option at GBP 0.58 strike at 3% premium which essentially an option to purchase GBP at (1/0.58) = 1.7241 irrespective of the spot rate on that date. The cost of purchasing the option is 3% premium = (200000 * 3% * 1.70) = $ 10200. Hence in this case if the exchange rate after 180 days is higher than 1.7241, then the company will exercise the option and purchase GBP at 1.7241 irrespective of the market rate and if it is below 1.7241, then the company can let the option expire. The maximum dollar cost will be = (1.7241 * 200000 ) + 10200 = $ 355020
D. Based on all the options, the least cost option in dollar terms is the money market hedge i.e. option B.