Question

Rizzo Company (RC) has GBP 1 million receivables due in one year. While the current spot price of GBP is USD 1.31, RC expects the future spot rate of British pound to fall to approximately $1.25 in a year so it decides to avoid exchange rate risk by hedging these receivables. The strike price of American-style put options are $1.29. The premium on the put options is $.02 per unit. Assume there are no other transaction costs. Finally, there is currently a forward premium on the one-year forward rate.

RC is considering two hedging strategies:

1. Sell GBP forward by entering into a forward contract. 2. Buy a
put option

Suppose that RC adopts Strategy 1 to hedge the GBP 1 million receivables and that these receiv- ables are a certain cash flow. Also, suppose that the current forward premium is such that the 12-month forward rate is USD 1.3300 per USD. If the forward market prediction is incorrect and the future spot rate turns out be USD 1.40 on the due date, how many US dollars will RC receive from those receivables?

A) USD 1,283,800

B) USD 1,310,000

C) USD 1,330,000

D) USD 1,400,000

Suppose that RC adopts Strategy 1 to hedge the GBP 1 million receivables and that these receiv- ables are a uncertain cash flow that is not paid to RC on the due date. Also, suppose that the current forward premium is such that the 12-month forward rate is USD 1.3300 per USD. If the forward market prediction is incorrect and the future spot rate turns out be USD 1.40 on the due date, what is the USD-denominated loss resulting from RC’s fulfilling the forward contract?

A) USD 10,000

B) USD 30,000

C) USD 50,000

D) USD 70,000

Suppose that RC adopts Strategy 2 to hedge the GBP 1 million receivables and that these receiv- ables are a certain cash flow. Also, suppose that the current forward premium is such that the 12-month forward rate is USD 1.3300 per USD. If the forward market prediction is incorrect and the future spot rate turns out be USD 1.40 on the due date, how many US dollars will RC receive from those receivables?

A) $1,290,000

B) $1,330,000

C) $1,400,000

D) $1,500,000

Suppose that RC adopts Strategy 2 to hedge the GBP 1 million receivables and that these receiv- ables are a certain cash flow. Also, suppose that the current forward premium is such that the 12-month forward rate is USD 1.3300 per USD. If the forward market prediction is correct and the future spot rate turns out be USD 1.25 on the due date, how many US dollars will RC receive from those receivables?

A) USD 1,250,000

B) USD 1,290,000

C) USD 1,330,000

D) USD 1,400,000

Suppose that RC adopts Strategy 2 to hedge the GBP 1 million receivables and that these receiv- ables are a uncertain cash flow that is not paid to RC on the due date. Also, suppose that the current forward premium is such that the 12-month forward rate is USD 1.3300 per USD. If the forward market prediction is incorrect and the future spot rate turns out be USD 1.40 on the due date, what is the loss to RC if it excises the put options, in addition to the paid premium and the loss of those receivables?

A) USD 100,000

B) USD 110,000

C) USD 120,000

D) USD 125,000

If you could explain or provide formulas, I would REALLY appreciate it. I want to UNDERSTAND it, not just get answers. Thanks!

Answer #1

1)

The strategy entered into by RC is selling GBP through a forward contract

since RC has to hedge 1 million GBP of receivables

The amount of GBP he will sell in this forward contract = 1,000,000 or 1 million

RC entered into the forward contract with a 12-month forward rate of USD 1.33 Per GBP

since actual spot rate after 1 year = USD 1.40 per GBP

1 million GBP = $1.4 million

hence, $1.4 million or $1,400,000 is received by RC after 1 year against the receivables

hence option D is correct

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