Question

Problem 2: Milos Inc. will be paying 500,000 Australian dollars in 180 days. Currently, a 180-day call option with an exercise price of $.68 and a premium of $.02 is available. Also, a 180-day put option with an exercise price of $.66 and a premium of $.02 is available. Mender plans to purchase options to hedge its payable position. Assuming that the spot rate in 180 days is $.65, what is the amount paid for the currency option hedge for the 500,000 Australian dollars?

1. Clearly state whether you will use the call or put to hedge.

2. Assuming that the spot rate in 180 days is $.65, what is the amount paid for the currency option hedge for the 500,000 Australian dollars?

Clearly show the cash flows from your strategy and clearly show your final answer.

Answer 1

Milos Inc. has to PAY 500,000 australian dollars. That means it needs to purchase australian dollars and hence CALL option will be takne to hedge.

180 day call option has an exercise price = $.66

Premium = $.02

Hence amount to be paid to purchase = 500000*.66 = $330000

Premium = 500000*.02 = $10000

Total cost =$340,000

If spot rate in 180 days = $0.65 :

It means that if we had not taken the option contract the cost would have been = 500000*.65 = $325,000

Hence cost of option contract comes out to be = 340,000-325,000 = $15000