Question

3M has signed a contract with the German government in order to supply 3 million facemasks...

  • 3M has signed a contract with the German government in order to supply 3 million facemasks worth €10 million. The German government will pay this amount in 120 days. 3M has decided to buy an option contract in order to hedge the exchange rate risk. Strike price is $0.9/€ and premium is 0.05$/€.
  • a. What type of option, call or put, is better for 3M to hedge the risk on this operation?

  • b. At what spot rate (t = 120 days) does it make sense for 3M to exercise the option?

  • c. Calculate the breakeven price (BEP)

  • d. Calculate the gain/loss under the following scenario (spot rate day 120): $1.01/€.

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Answer #1

Ans:

Contract price : €10 million

3M will receive the payment after 120 Days. Now 3M has a risk that $/€ will fall over the time. So Hedge it bought a put option at a strike price $0.9/€.

Option Premium : 0.05$/€

a.

Put option is better for 3M to hegde the risk of operation.

b.

At any spot rate less than $0.9/€, it makes sense for 3M to exercise the option.

c.

Breakeven Point of hedging is where 3M has no profit and no loss after adjusting its premium cost.

Break even Point : $0.9- $0.05 = $0.85/€

At 0.85 $/€ 3M will have not profit no loss on hedging its risk.

d.

If spot rate increase to $1.01/€, Put option will lapse. Cost of buying put option will be loss for 3M:

Premium cost : $0.5/€

= 10,000,000 * $0.05 = $500,000

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