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 £. What is the foreign exchange risk that the FI is facing, and what type of currency option should be purchased to hedge this risk?
A)The FI should use put options to hedge the depreciation of the dollar.
B)The FI should use call options to hedge the depreciation of the pound sterling.
C)The FI should use put options to hedge the depreciation of the pound sterling.
D)The FI should use call options to hedge the depreciation of the dollar.
E)The FI should use put options to hedge the appreciation of the pound sterling.

Question

Quizplus · Accepted Answer

The FI is facing the risk of depreciation of the pound sterling, which would result in a loss when the T-bill is repaid in pounds and converted back to dollars. Therefore, the FI should purchase put options to hedge against this risk. Given the exercise price of $1.60/£1, the options on foreign currency futures contracts appear to be more cost-effective than the one-month options on sterling. Therefore, the FI should purchase put options on foreign currency futures contracts.

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