Question

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$20,000 if you choose to hedge via call option on US$.

2. Calculate the future ringgit cost of meeting this US$ obligation if you decide to hedge using a forward contract.

3. At what future spot exchange rate will you be indifferent between the forward and option market hedges?

4. 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

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$