Question

You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.

Information for Forward Contract:

Forward exchange rate (one yr): 1.54 $/BP

Information for Money Market Instruments (MMI):

Current exchange rate: 1.50 $/BP

Investment return at Aerion Fund Management (in UK): 4% annual

Interest rate of borrowing from Bank of America (in USA): 2% annual

Information you need for Currency Options Contract:

Options premium: 0.015 $/BP

Interest rate of borrowing from Bank of America (USA): 2% annual

Allowed to exercise options at 1.54 $/BP

If the break-even exchange rate for the Currency Options Contract is 1.46 $/BP, and you believe the exchange rate at the time of the payment would be 1.53 $/BP, should you sign the contract?

Answer 1

Since we have amount payable in UK,to hedge we need to invest on an asset that will return 500000BP in a year.

So investment to be made in UK will be =5000000/1.06=471698.13BP (6% interest received)
So amount equivalent to 471698.13BP should be borrowed at the beginning of the year from USA @ 2% interest.
Amount to be borrowed in US $ =471698.13*1.5 = 707547.195 US$
Amount to be repaid after 1 year =707547.195*1.02 = 721698.138US$
So interest paid/cost of MMI= $14150
The asset in UK will be realised at year end and the same will be used to payoff the payable of 500000BP at year end.

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