Question

Alfred owes GBP 1M in one year, but all of his assets are in USD. He...

Alfred owes GBP 1M in one year, but all of his assets are in USD. He wishes to use options to reduce his exposure to exchange rates. He has the following options available to him for purchase. You may ignore option premia for the purposes of this question, and assume he can choose an option with whatever quantity of the underlying asset he wishes – if he chooses an option with USD as the underlying, he can choose any quantity of USD.

Option

Strike Price

Maturity

Underlying Asset

Long Call

USD 1.25 per GBP

1 year

GBP

Long Put

USD 1.15 per GBP

1 year

USD

Long Put

USD 1.20 per GBP

1 year

GBP

Long Call

USD 1.10 per GBP

1 year

USD

4A. Which one of these options should he choose?

4B. What should he set the underlying asset to?

4C. Will he exercise the option if the spot rate is USD 1.19 per GBP in one year?

4D. If the spot rate is USD 1.19 per GBP in one year, what exchange rate will he actually be buying his GBP at?

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Homework Answers

Answer #1

Alfred has GBP one million payable so he is afraid of GBP rising against dollar

to hedge the same he will buy call option on GBP which gives alfred positive payoff when GBP rises

OR he can buy a put option on USD which gives alfred positive payoff when GBP rises (ie USD falls)

4A since it is specifically given in the question "if he chooses an option with USD as the underlying"

he will buy/long USD 1.15 per GBP put with underlying asset USD

4B he should set his underlying asset to USD

4C he will excercies the option because option is In the money (ITM)

4D he is holding put opton on USD (ie he has the right to sell USD (ie buy GBP at USD 1.15 per GBP) so he will buy his GBP at USD 1.15 per GBP

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