Question

Trefor, a US firm, has a sterling (£) receivable of £300,000 from a UK customer due one year from now. Trefor has no use for sterling currency and will exchange the receipt into US dollars ($). The spot exchange rate now is £1=$1.34 and the one-year forward exchange rate is £1=$1.31. Assume the forecasted spot rate in one year’s time is £1=$1.28 or £1=$1.38, with equal probability. The discount rate is zero.

(a) What is the expected dollar value of Trefor’s receivable if it chooses: (i) not to hedge the receipt? (ii) to use a forward hedge?

(b) One year sterling put options and sterling call options are available at a cost of $0.03 per £ with an exercise price of £1.32. (i) How could Trefor make use of an option hedge for its sterling receivable? (ii) What will be the expected value in dollars of the outcome of the option hedge?

(c) If Trefor is concerned only about downside risk, is it better to choose the forward hedge or the option hedge? Explain.

Answer 1

a)

i) Expected value of receivables ($) in case receipt is not hedged

= expected exchange rate * receivables in pound

=(0.5*1.28+0.5*1.38)*300000

= $399000

ii) Expected value of receivables ($) in case forward hedge is used

= forward exchange rate * receivables in pound

=1.31*300000

= $393000

b)

i) Trefor could hedge its sterling receivables by buying the $1.32 strike put options at $0.03 , thereby ensuring that the minimum realised exchange rate is $1.32-$0.03 =$1.29

So, the minimum amounts of Dollar received by Trefor would be $387000

ii) If Trefor is only concerned with downside risk and not lured by the potential upside, the forward hedge is better as it is giving a higher realisation amount in Dollars than put options