Question

You plan to visit one of your friends living in Colorado, America in three months. You...

You plan to visit one of your friends living in Colorado, America in three months. You expect to incur the total cost of US$20,000 for lodging, meals, and transportation during your stay. As of today, the spot exchange rate is RM_____/ US$ and the three-month forward rate is RM_____/ US$ (please refer to Table 1 below for your given rates). You can buy the three-month call option on US$ with the exercise rate of RM4.3/ US$ for the premium of RM1 per US$. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 3.2 percent per annum in Malaysia and 2 percent per annum in the United States.

  1. Calculate your expected ringgit cost of buying US$20,000 if you choose to hedge via call option on US$.
  1. Calculate the future ringgit cost of meeting this US$ obligation if you decide to hedge using a forward contract.
  1. At what future spot exchange rate will you be indifferent between the forward and option market hedges?
  1. Illustrate the future ringgit costs of meeting the US$ payable against the future spot exchange rate under both the options and forward market hedges.

TABLE1

S(RM/USD) F3m(RM/USD)
4.195 4.245

Homework Answers

Answer #1

a. Hedge via call option on US$.

Cost of option =20000*1 RM=20000RM

Exercise rate=RM4.3/US$

Payoff on Call Option if price at expiration=4.245

Payoff=0

(Loss) on Call option=(20000)RM

Price for buying 20000 US$ at the end of three months=20000*4.245=84900 RM

Expected Ringitt Cost=84900+20000=104,900 RM

Hedge using a forward contract.

Expected Ringitt Cost=20000*4.245=84900 RM

You be indifferent between the forward and option market hedges:

Expected Ringitt Cost on option market to be indifferent=84900 RM

Loss on Call Option =20000RM

Price for buying 20000 US$ at the end of three months=84900-20000=64900RM

Future spot exchange rate=64900/20000=3.245 RM/US$

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