Question

PLEASE SHOW WORK

You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.

(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.

(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?

(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

PLEASE SHOW WORK

Answer 1

Buying Cost = SF5,000
Spot exchange rate = $0.60/SF
3 month forward rate = $0.63/SF, Premium = $0.05/SF
3 month call option (exercise rate) = $0.64/SF
3 month interest rate (US) = 6%
3 month interest rate (Switzerland) = 4%

a) Buying cost = SF5000
Premium = SF5000 * 0.05 = $250
Future value(in 3 months) = $250 * 1.015 = $253.75
Here, future spot rate is less than the exercise rate, hence you dont need to exercise this option
You buy SF5000 @ 0.63/SF = SF5000 * 0.63 = $3150
Therefore, Total cost of buying = $3150 + $253.75 = $3403.75

b) The future dollar cost of meeting this SF obligation using a forward contract = SF5000 * 0.63 = $3150

c) The spot rate (buying)
$3150 = 5000x + $253.75
5000x = $3150 - $253.75
5000x = $2896.25
x = $2896.25/5000
= 0.57925/SF

d) Exercise rate = $0.64/SF
Exercise price of call option = SF5000 * $0.64 = $3200
Total cost of buying = $3200 + $253.75 = $3453.75