Question

Your US company has a payment due of €7,000,000 next year. Your CEO wants to implement an options hedge. Should you buy a call or put? Both the call and put strikes are $1.15/€. The call costs $0.02/€ and the put costs $0.04/€. What is the amount of dollars you will pay (factoring in the profit/loss of the option) if the spot rate finishes at $1.20/€ next year?

Answer 1

You should buy a call option on the euro since you are expecting to pay euros and want to hedge against the increase in the value of the euro. The call option gives you the right to buy euros at the rate determined today. So, if the euro increases in value you can buy euros at the strike $1.15 / euro.

Profit of long call option = max(St - X, 0) - premium paid

Profit = max(1.20 - 1.15, 0) - 0.02

Profit = 0.05 - 0.02 = $0.03 per euro

or 7,000,000*0.03 = $210,000

Since the spot (1.20) > Strike (1.15) you buy euros at the strike.

So, you pay 7,000,000*1.15 = $8,050,000

And you pay  0.02*7,000,000 = $140,000 for call option

Total amount you pay = 8,050,000 + 140,000 = $8,190,000

Without the call option you would have paid 7,000,000 * 1.20 = $8,400,000

Your profit is 8,400,000 - 8,190,000 = $210,000

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