Currency Hedging - Options

CFA Level III
#1

Reading 35 - Currency Hedging EOC#7

For those that don’t have the question in front:

You are British Investor, will receive $15M in 3 months. Current Spot $1.5/pound, and 3 month Forward $1.5/pound.

Calls on the British Pound are:

X:1.50 $/Pound, C: 0.03 pounds

X:1.55 $/Pound, C: 0.015 pounds

X:1.60 $/Pound, C: 0.005 pounds

Insure using 1.50 Calls and assume Spot in 3 months = 1.70.

I look at the answer and believe I get it… But it would be appreciative if someone might break this up for me.

Thanks

#2

What’s the question?

#3

Yeah… i have the same question. Here is a thread that also refers to this problem:

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91307740

I think there is an error in the book… but maybe I am not seeing something obvious…

#4

how they got to the option premium was confusing. I got everything else.

#5

That’s whats throwing me off.

#6

Given all that information, the questions says:

Calculate the Pound value of the 15M received in three months assuming that the Pound: spot rate in March (which is T3months) is equal to 1.7 dollars per pound.

#7

The option premium is in the table, it’s 0.03 per call for the 1.50 strike price. You have $15 mil. and you’ll buy £10 mil. in calls to perfectly hedge that based on the forward contract. So the 0.03 per call times the £10 mil. is the 300,000 option premium, which will be your loss if the currency rate is less than the strike price and your calls expire out of the money.

#8

movingroup: that is what most of us did. The answer in the text uses 200,000 as the premium as they take the 300K and divide again by the 1.5 exchange rate. Seems like they do this twice. But last year candidates had same issue and this is still in book

#9

This is the given answer:

Insured portfolio using March 1.50 calls.: Remeber you can insure using a put to sell for Pound or buying a call to buy pound for .

Option Premium: $15,000,000 / $1.5/pound *0.03 pounds = $300,000 or 200,000 pounds = $300,000 / 1.5

Current Price: 1.7 / pound and X: 1.5/pound

Profit on Call: (15,000,000 / 1.5) - (15,000,000 / 1.7) = 1,176,471 pounds

Dollar Depreciation: (15,000,000 / 1.7) - (15,000,000 / 1.5) = -1,176,471 pounds

Net position: 1,176,471 - 1,176,471 - 200,000 (all in pounts) = -200,000 pounds

Portfolio Value: 10,000,000 pounds - 200,000 pounds = 9,800,000 pounds.

#10

Andy, thanks for the reinforcement. It doesn’t make sense to for the ‘double conversion’ for the premium. But thought I ask - currency and options aren’t my forte and perhaps I was missing something…

#11

Oooopss… sorry I didn’t totally understand what the issue was :slight_smile: The chart also says that the prices are in $ per £ so maybe that’s why it’s converted again. I’m pretty sure I got this one right when I first did it, but now I feel like it must’ve been luck…

#12

The problem now makes total sense :slight_smile: There is no error.

Here is a breakdown.

So, the call premium is $0.03/pound

Current exchange rate is $1.5/pound

$15,000,000 translates to 10,000,000 pounds (=15M/1.5).

Now, to get the total option premium:

10,000,000 pounds x $0.03/pound = $300,000

Now we need to convert this premium back to pounds, so we divide it by the current Exchange rate of $1.5/pound:

$300,000 / $1.5/pound = 200,000 pounds

Now I can sleep better tonight…