Question

Use the following to answer questions 14 - 16: PQR Associates will owe EUR 100,000 in one year. It is concerned about appreciation of the EUR and is considering possible hedging techniques. The following market and exchange conditions apply: One Year Forward Rate EUR Interest Rate US Interest Rate USD 1.20 5% 8% Call Option Exercise Price Call Option Premium Today’s Spot Rate USD 1.20 USD .03 USD 1.18 PQR has forecasted exchange rates and has developed the following probability distribution for the expected 1 year exchange rate: 1 Year Exchange Rate USD 1.16 USD 1.22 USD 1.24 Probability 20% 70% 10%

If PQR hedges with a Call Option Hedge, what is the cost of their payables in 1 year?

USD 122,200

USD 121,371

USD 120,000

USD 117,000

Answer 1

Call option is the right to buy at the pre specified rate on paying a premium.

The call option is exercised only if the spot rate on maturity is more than the Exercise Price

Call premium paid will be part of the cost whether exercised or not.

Spot Price after 1 year	Decision	Cost	Probability	Expected Cost
1.16	Not Exercise	(1.16+0.03)*100000	0.2	23800
1.22	Exercise	(1.2+0.03)*100000	0.7	86100
1.24	Exercise	(1.2+0.03)*100000	0.1	12300
			Expected Cost	122,200

Hence, Cost of payables under Call Option Hedge = 122,200