Millau has a contract to deliver computerized machine tools to a U.S. buyer in three months. A payment of 50 million U.S. dollars (USD50,000,000) is due from the buyer at that time. Gide is concerned about the dollar weakening relative to the euro. She plans to use options to hedge this currency exposure. Specifically, Gide expects the U.S. dollar to weaken to 1.2250USD/EUR in the next three months. Euro options quotations are given in Exhibit 2. All options are European-style and expire in three months. the answer is : If Gide remains unhedged and her expectation of a future exchange rate of 1.225 USD/EUR comes true, the $50,000,000 will convert to €40,816,327. If she buys a call on the euro (the right to buy euros with dollars) with a strike of 1.18, her effective conversion rate will be 1.2075 (1.18 (the strike) + 0.0275 (the call premium)). Continuing, 50,000,000 / 1.2075 = 41,407,867. This exceeds the expected amount of euros under the unhedged option. Answers B and D do not provide a hedge against a weaker dollar. how to understand "conversion rate will be 1.2075 (1.18 (the strike) + 0.0275 (the call premium)). "??
The same question is now in CFA readings, book 5, page 534, q12. Can anybody explain the logic behind calculation of “effective conversion rate”?
i think it’s just the (option strike price + option premium) times the number of contracts. Meaning, she pays Eur .0275 per USD converted to buy the option.