Question

You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur a 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 a three-month call option on SF with the exercise rate of $0.66/SF for a premium of $0.13 per SF. Assume that your expected future spot exchange rate is $0.61/SF. The three-month interest rate is 0.08 per annum in the United States and 0.03 per annum in Switzerland. Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via the call option on SF.

Answer 1

Solution: Information given in the question:

Swiss france required after 3 months: SF 5,000

Hedging Technique to be used: Call option

Spot Rate: $0.60/SF

Call Option details: Exercise Rate: $0.66/SF

Option Premium: $0.13/SF

3 months interest rate: U.S.= 8% p.a.

Switzerland = 3% p.a.

Expected future (3 months) spot rate: $0.61/SF

Dollar Cost of buying SF 5000 after 3 months:

As per the information given, the expected future spot rate is $0.61/SF which is lesser than the exercise rate after 3 months i.e.$0.66/SF. No call buyer would exercise the option if the same currency he/she can buy from the market at lesser price.

Option Premium: $650 ($0.13 * SF5000)

Opportunity Cost of Option Premium: $13 ($650 * 8/100 * 3/12)

Future Spot Exchange Rate: $3,050 (SF5,000 * $0.61)

Total Cost of buying SF 5,000: $3,713