Trade any excess foreign currency at the spot rate

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Reference no: EM132003970

Forwards and Derivatives

You are a manager of Collina LLC, a small American importer of European goods. You have struck a deal with a major French company for EUR 7.1M worth of goods. The deal states that you must pay in EUR in 90 days. The current EURUSD exchange rate is 1.18. The premium for a 90 days EUR call option with strike price 1.19 is 0.017 USD for EUR of notional. The premium for a EUR put option with same strike price and maturity is 0.014 USD per EUR of notional. One Euro option is worth 125,000 EUR. Note: Ignore the time value of money. Hint: Notice that the foreign currency amount is not a multiple of the option contract size, so they can only hedge a bit less or a bit more than their actual FX exposure (e.g. if they would need 10.3 contracts, they could either use 10 or 11 contracts). If the hedge a bit less, part of the exposure will be not hedged. If they hedge a bit more, they will have to buy or sell the extra foreign currency at the spot rate.

A. Assume that Collina LLC decides to hedge the FX exposure with option contracts. What kind of options would they buy?

B. If they decide to not hedge an amount larger than their FX exposure, what is the amount of total dollar expense (as a function of the spot rate in 90 days) that Collina LLC will incur if in 90 days the spot rate is above 1.19 (i.e. the cost of goods plus the cost of hedging)?

C. What would be the total dollar expense if, instead, they decide to hedge all their exposure and trade any excess foreign currency at the spot rate?

Reference no: EM132003970

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