Reference no: EM132933956

Arthur Doyle is a currency trader for Baker Street, a private investment house in London. Baker Street's clients are a collection of wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.

Arthur is convinced that the British pound will slide significantly -- possibly to $1.3200/£ -- in the coming 30 to 60 days. The current spot rate is $1.4260/£. Arthur wishes to buy a put on pounds which will yield the 25% return expected by his investors.

Problem a) Which of the following put options would you recommend he purchase.

Problem b) Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense (in terms of return and risk).

Problem c) We understand that futures and options can also be used for hedging purposes. If Arthur expects to receive £250,000 in 60 days and wants to lock in a future sales price for his pounds, what would he do? What are the profits/losses if the actual exchange rate is $1.3200/£ in 60 days? What if pound futures and forwards are also available, how you can hedge the currency risk? What are the differences between futures and forwards for this purpose?

Strike Price           Maturity          Premium
$1.36/£              30 days          $0.00081/£
$1.34/£              30 days         $0.00021/£
$1.32/£             30 days           $0.00004/£
$1.36/£             60 days           $0.00333/£
$1.34/£            60 days          $0.00150/£