Crown Co. is expecting to receive 100,000 British pounds in one year. Crown expects the spot rate of the British pound to be $1.49 in a year, so it decides to avoid exchange rate risk by hedging its receivables. The spot rate of the pound is quoted at $1.51. The strike price of put and call options are $1.54 and $1.53, respectively. The premium on both options is $.03. The one-year forward rate exhibits a 2.65 percent premium. Assume there are no transaction costs. What is the best possible hedging strategy and how many U.S. dollars Crown Co. will receive under this strategy?

Question

​Crown Co. is expecting to receive 100,000 British pounds in one year. Crown expects the spot rate of the British pound to be $1.49 in a year, so it decides to avoid exchange rate risk by hedging its receivables. The spot rate of the pound is quoted at $1.51. The strike price of put and call options are $1.54 and $1.53, respectively. The premium on both options is $.03. The one-year forward rate exhibits a 2.65 percent premium. Assume there are no transaction costs. What is the best possible hedging strategy and how many U.S. dollars Crown Co. will receive under this strategy?

Quizplus · Accepted Answer

The best hedging strategy is to sell pounds forward at the one-year forward rate with a 2.65% premium. This will provide a guaranteed exchange rate of $1.5149 (1.49*1.0265) per pound, which is better than the spot rate of $1.51 per pound. Selling pounds forward will lock in the exchange rate and eliminate exchange rate risk. Therefore, Crown Co. will receive ($1.5149 x 100,000) = $151,490 in U.S. dollars.

​Crown Co Is Expecting to Receive 100,000 British Pounds in One

Crown Co Is Expecting to Receive 100,000 British Pounds in One