Question

Suppose you will receive US$100 million in three months and you would like to exchange the money to CAD. What option strategies can you use to guarantee an exchange rate between 1.2 and 1.3?

Answer #1

Option strategy to hedge currency risk would be to buy an option in the currency futures contract i.e. buy a CAD currency futures contract to sell 1 USD for 1.3 CAD with exercise date in 3 months.

This option gives a right to buy CAD currency contract but not an obligation i.e

**Scenario 1 -** if after 3 months, 1 USD = 1.3 or
>1.3 CAD option holder can exchange USD to CAD at spot rate and
only loss will be in terms of money spent to buy the option, which
is usually say less than .1 CAD per unit i.e. effective exchange
rate locked in will be between 1.2 to 1.3 CAD

**Scenario 2 -** Again, if at the end of 3 month 1
USD =less than 1.3 CAD, option holder can exercise the option and
convert USD to CAD at 1.3 CAD per USD. Again the effective exchange
rate accounting for transaction cost for option will be around 1.2
to 1.3 CAD per USD.

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