Money and Foreign Exchange

Questions: A US importer will have a net cash outflow of EURO2,500,000 in payment for goods bought in January 2015 (assumed to be 0.25 years away). The importer wishes to hedge this risk to avoid the exchange rate risk and is considering hedging using (i) at the money call options on the pound; (ii) a forward contract and (iii) a combination of calls and puts.The prevailing market data is given below:Market Data (1st October 2014)Spot Exchange Rate = $1.2596/EuroThree month Euro interest rate = 0.1% p.a.Three month US Dollar interest rate = 0.3% p.a.Premium on a May Euro Call Option, Strike = $1.24/Euro = 2.89 cents/EuroPremium on a May Euro Call Option, Strike = $1.26/Euro = 1.72 cents/EuroPremium on a May Euro Call Option, Strike = $1.28/Euro = 0.91 cents/EuroPremium on a May Euro Put Option, Strike = $1.24/Euro = 0.87 cents/EuroPremium on a May Euro Put Option, Strike = $1.26/Euro= 1.70 cents/EuroPremium on a May Euro Put Option, Strike = $1.28/Euro = 2.89 cents/EuroRequired:1. What is meant by covered interest parity? Using the data above calculate a three month forward rate to buy Euros for dollars.2. Explain, using the market data above, how call options on foreign currenct can be used to establish a ceiling price when purchasing foreign currency and how put options can be used to establish a floor price when selling foreign currency.3. Consider, using the market data above, the obligations on the SELLER of each of these calls and puts if the option were to be exercised. Identify the circumstances when the options would be exercised. Answers: 1. Covered Interest Parity Covered Interest Parity is such situation where the interest rate becomes almost equal to currency value of two nations. In such situation, any arbitrage opportunities or return cannot be possible to earn doing trading between the currencies of two countries (Aizenman, J. and Hutchison, M. 2010). As for example, the currency value and interest rate of Country A and Country B are same. The interest rates of Country A and Country B are respectively 10% and 7%. An investor borrows a certain amount in the currency of Country B and he thinks to invest the money in the currency of Country A. So, it is required to convert the money with spot price of Country A. For the repayment of borrowing money, the investor needs to go for a forward back for bringing back the money from the currency of Country A to Country B. At that time, the inventors cannot earn any profit due to existence of covered interest parity. Covered interest parity eradicates the entire profits from the trading of currency (Chandler, M. 2009). Calculation of Forward Rate Forward is the currency exchange rate for future. A commercial bank gives guarantee to exchange the currency of a country to another currency of a country and obviously at a specified future date. It is calculated on the basis of spot price of currency (Chen, J. 2009). Forward can be calculated by using following formula: Where, S is spot exchange rate of two countries. rd is domestic interest rate rf is foreign interest rate Given, Spot Exchange rate is $1.2596/Euro Three months Euro interest rate is 0.1% p.a. Three month US Dollar interest rate is 0.3% p.a. It is assumed that the total number of days in a year is 360 (Croke, L. 2009). So, the forward rate is calculated as follows: =1.2589 Therefore, the three months forward rate of Dollar and Euro is 1.2589. 2. Establishment of Ceiling Price through call options on foreign currency when purchasing Ceiling price is the highest price where buyer has to pay for buying the options. Ceiling price is the highest price limit where sell can charge against an option (Cuhaj, G. 2009). If the ceiling is price is greater than the current spot price than buyer of the call option can exercise the options. Ceiling Price = Strike Price + Premium Strike price is price of a option which is the particular price at which the currency option can be purchased or sold by the possessor or the purchaser of the option contract (Davidson, A. 2009). Usually, the strike price is set which is closer to current spot price. Premium is a price which is paid by the buyer of an option for right to buy or sell the option. The premium price is paid to seller of an option (Dobeck, M. and Elliott, E. 2007). Strike Price Premium Ceiling Price Situation $1.24 0.0289 $1.27/Euro Ceiling Price Spot Price $1.26 0.0172 $1.28/Euro Ceiling Price Spot Price $1.28 0.0091 $1.29/Euro Ceiling Price Spot Price Here, the spot price is $1.2596/Euro. It is observed in the above table that the all the cases have the ceiling price greater than the current spot price of option. So, the buyer may not exercise the option. Establishment of Floor Price through put options on foreign currency when selling Floor price is the lowest price at which seller of the option allows to sold the option. If the floor price is less than current spot price the seller of the put option would not exercise the option (Fabozzi, et al, M. 2002). Floor Price = Strike Price Premium Strike Price Premium Floor Price Situation $1.24 0.0087 $1.23/Euro Floor Price Spot Price $1.26 0.017 $1.24/Euro Floor Price Spot Price $1.28 0.0289 $1.25/Euro Floor Price Spot Price In the above table, it can be seen that the all the case of put options have the floor price is less than the current spot price of option. So, the seller may not exercise the option (Homberg, D. and Troltzsch, F. 2013). 3. Obligations on the Seller of given each calls and puts Seller obligation on call options The obligation of seller is to sell the underlying security if the call option is exercised by the call purchaser on or before the expiry date of option (Jacque, L. 2010). If the spot price is less than equal to exercise price or strike price, the seller only can earn the premium amount from the call option (Landuyt, G. et al R. 2009). When the spot price of currency call option is greater than the strike price or exercise price, the seller may have to bear loss beyond the premium amount (Makin, A. 2009). In case of Spot Price Strike Price, Sellers Payoff for Call Option (US$/Euro) = Premium Price In case of Spot Price Strike Price, Sellers Payoff for Call Option (US$/Euro) = Spot Price - (Strike Price + Premium) Strike Price Premium Spot Price Payoff $1.24 0.0289 $1.2596 ($0.0093) $1.26 0.0172 $1.2596 $0.0172 $1.28 0.0091 $1.2596 $0.0091 According to the above table, it can be observed that the payoff of selling a call option is negative. So, at strike price of $1.24, seller has to bear loss of $0.0093 if it is exercised by the call buyer (Neaime, S. and Colton, N. 2005). At strike price $1.26; the seller can earn the profit equal to premium price $0.0172 if the call holder exercises the option. At strike price $1.28; the seller also can earn only the premium price $0.0172 if it is exercised by the call buyer. Seller obligation on put options The obligation of seller in case of put option is to purchase the underlying security if the pet option is exercised by the put holder on or before expiry date (Rebonato, et al 2009). If the spot price is less than equal to exercise price or strike price of a put option, the seller may earn or may have to bear the loss. The loss or earnings depends on the premium amount of the put option. When, the spot price is greater than the strike price, the seller can earn only the premium amount of put option (Ramaswamy, S. 2011). In case of Spot Price Strike Price, Sellers Payoff for Put Option (US $/Euro) = (Spot Price Strike Price) + Premium In case of Spot Price Strike Price, Sellers Payoff for Put Option (US $/Euro) = Premium Price Strike Price Premium Spot Price Payoff $1.24 0.0087 $1.2596 $0.0087 $1.26 0.017 $1.2596 $0.0166 $1.28 0.0289 $1.2596 $0.0085 In case of strike price of $1.24, the seller can only earn the premium amount ($0.0087) of the put options if it is exercised by the put buyer. In case of strike price of $1.26, the seller can gain more ($0.0166) from selling of put option if it is exercised by the put buyer. In case of strike price of $1.28, the seller can also gain profit of $0.0085 from the selling of put option if it is exercised by the put buyer. Circumstances when the options would be exercised Buyers Payoff for a call option Strike Price Premium Spot Price Payoff $1.24 0.0289 $1.2596 -$0.0093 $1.26 0.0172 $1.2596 -$0.0172 $1.28 0.0091 $1.2596 -$0.0091 The above table describes that, the buyer has to bear loss less at $1.24 among the others strike prices. In case of others strike prices, the buyer can suffer equal to premium price. Buyers Payoff for a put option Strike Price Premium Spot Price Payoff $1.24 0.0087 $1.2596 -$0.0087 $1.26 0.017 $1.2596 -$0.0166 $1.28 0.0289 $1.2596 -$0.0085 According to the above table, it is observed that the buyer can bear loss equal to premium price at strike price $1.24. The highest loss will be at strike price $1.26. The loss is less at strike price $1.28 among the others strike prices (Senders, S. and Truitt, A. 2007). 4. Calculation on market data: Table 1: Price on expiry date Exercise price Premium in cents Pay off Exercise Price Premium in cents Pay off Net Pay Off 1.20 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.21 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.22 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.23 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.24 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.25 1.25 2.89 (2.89) 1.25 0.87 0.87 (2.02) 1.26 1.25 2.89 0.05 1.25 0.87 (0.01) 0.04 1.27 1.25 2.89 0.07 1.25 0.87 (0.02) 0.05 1.28 1.25 2.89 0.09 1.25 0.87 (0.03) 0.06 1.29 1.25 2.89 0.11 1.25 0.87 (0.04) 0.07 1.30 1.25 2.89 0.14 1.25 0.87 (0.05) 0.09 1.31 1.25 2.89 0.16 1.25 0.87 (0.06) 0.10 1.32 1.25 2.89 0.18 1.25 0.87 (0.07) 0.11 According to the table 1, the research analyst analyses that United States of American importer has hedged his money and the analyst observed that the importer has faced a loss by hedging his portfolio. The total net pay off the U.S. importer is -11.60 in cents (Singh, M. 2010). Table 2: Price on expiry date Exercise price Premium in cents Pay off Exercise Price Premium in cents Pay off Net Pay Off 1.20 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.21 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.22 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.23 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.24 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.25 1.25 1.72 (1.72) 1.25 1.70 1.70 (0.02) 1.26 1.25 1.72 (0.80) 1.25 1.70 0.53 (0.27) 1.27 1.25 1.72 (0.79) 1.25 1.70 0.52 (0.27) 1.28 1.25 1.72 (0.78) 1.25 1.70 0.51 (0.27) 1.29 1.25 1.72 (0.77) 1.25 1.70 0.50 (0.27) 1.30 1.25 1.72 (0.76) 1.25 1.70 0.49 (0.27) 1.31 1.25 1.72 (0.75) 1.25 1.70 0.48 (0.27) 1.32 1.25 1.72 (0.74) 1.25 1.70 0.47 (0.27) According to the table 2, the research analyst analyses that United States of American importer has hedged his money and the analyst observed that the importer has faced a loss by hedging his portfolio. The total net pay off the U.S. importer is -2.01 in cents (Williams, R. 2011). Table 3: Price on expiry date Exercise price Premium in cents Pay off Exercise Price Premium in cents Pay off Net Pay Off 1.20 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.21 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.22 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.23 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.24 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.25 1.25 0.91 (0.91) 1.25 2.89 2.89 1.98 1.26 1.25 0.91 (0.02) 1.25 2.89 0.04 0.02 1.27 1.25 0.91 (0.01) 1.25 2.89 0.02 0.01 1.28 1.25 0.91 0 1.25 2.89 0 0 1.29 1.25 0.91 0.01 1.25 2.89 (0.02) (0.01) 1.30 1.25 0.91 0.02 1.25 2.89 (0.04) (0.02) 1.31 1.25 0.91 0.03 1.25 2.89 (0.06) (0.03) 1.32 1.25 0.91 0.04 1.25 2.89 (0.08) (0.04) According to the table 3, the research analyst analyses that United States of American importer has hedged his money and the analyst observed that the importer has made a profit by hedging his portfolio. The total net pay off the U.S. importer is 11.85 in cents (Zeldes, S. and Geanakoplos, J. 2009). The research analyst observed that the U.S. importer has made a loss from his portfolio by hedging in different ways. From the above three table i.e., table 1, table, and table 3, the importer has made a loss of (11.6) cents from the table 1, from table 2 the importer has made a loss of (2.01) cents and from table 3 the importer has made a profit of 11.85 cents. But the total net loss made by the importer by hedging is (1.76) cents (Makin, A. 2009). References: Aizenman, J. and Hutchison, M. (2010). Exchange market pressure and absorption by international reserves. Cambridge, Mass.: National Bureau of Economic Research. Chandler, M. (2009). Making sense of the dollar. New York: Bloomberg Press. Chen, J. (2009). Essentials of foreign exchange trading. Hoboken, N.J.: John Wiley. Croke, L. (2009). I'm broke!. St. Catharines, Ont.: Crabtree Pub. Cuhaj, G. (2009). Standard catalog of world paper money. Iola, WI: Krause. Davidson, A. (2009). How the global financial markets really work. 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