Question

American Standard Co. has a 90 day £62,500 receivable. American Standard’s bank, Bank of America, suggests a call option contract that matures in 90 days. American Standard purchases one call option contract, where one contract corresponds to a quantity of £62,500. American Standard is:

Hedging.

Speculating.

Locking in an arbitrage profit.

Answer 1

The correct answer is b) Speculating

American Standard has exposure to the $/£ exchange rate fluctuation as it is expected to receive £62,500 in the future. By buying a call option on the £, the company is increasing its risk and betting that £ would go up. But, if £ falls then the company incurs a significant loss in both the call option position and on the amount received. So, clearly, the American Standard is speculating.

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