In April 2016, an FI bought a one-month sterling T-bill paying £100 million in May 2016.The FI's liabilities are in dollars, and current exchange rate is $1.6401/£1.The bank can buy one-month options on sterling at an exercise price of $1.60/£1.Each contract has a size of £31,250, and the contracts currently have a premium of $0.014 per £.Alternatively, options on foreign currency futures contracts, which have a size of £62,500, are available for $0.0106 per £. If the exchange rate in one month is $1.55/£1, what action should the FI take in regards to the hedge?
A)Call the £100 million proceeds of the T-bill from the option writer for $160 million
B)Put the £100 million proceeds from the T-bill to the option writer for $160 million.
C)Put the £100 million proceeds from the T-bill to the option writer for $155 million.
D)Call the £100 million proceeds of the T-bill from the option writer for $155 million
E)Allow the option contracts to expire since they are out of the money.

Question

Quizplus · Accepted Answer

The FI should use put options to sell the £100 million at the exercise price of $1.60/£1, since the actual exchange rate ($1.55/£1) is less favorable than the exercise price. This action ensures the FI receives $160 million instead of the lower amount it would get at the current exchange rate.

In April 2016, an FI Bought a One-Month Sterling T-Bill