Question

A U.S. company is to sign a contract for 16 million HK dollars (HKD) that will be paid shortly in the future. Given the current exchange rate of HKD4.0 per U.S. dollar, this amount is consistent with the company’s target of 4 million U.S. dollars for its services. Assume it is July and that the contract amount will be paid on 30 September. The following September option quotes are available in the market today to help hedge against exchange rate risk:  

• A call option with a strike of HKD4.03 at a premium of HKD0.02
• A put option with a strike of HKD4.03 at a premium of HKD0.01

Note that the option premiums are quoted in exchange rate terms. The size of each option contract is for 1,000,000 HKD.

Which option and position should be used in this hedging strategy? Using min or max notation, what is the payoff and profit function of the preferred option?

Answer 1

In this question, the company wants to sell 16 million HKD in the future. Hence, they have to protect themselves from the depreciation of HKD i.e. the HKD per USD going up.  So, they would have to use the call option which enables them to buy the USD or sell the HKD at HKD4.03 per USD in the future. Thus, even if the exchange rate goes to HKD5 per USD they would be safe. The payoff of the call option will be given as = max(S-K,0) = Max(S - 4.03,0) per USD. The profit will be given as = Max(S - 4.03,0) - 0.02 HKD per USD.