Suppose that the exchange rate is €1.25 = £1.00.Options (calls and puts)are available on the London exchange in units of €10,000 with strike prices of £0.80 = €1.00.Options (calls and puts)are available on the Frankfurt exchange in units of £10,000 with strike prices of €1.25 = £1.00.For an Italian firm to hedge a £100,000 payable,
A)buy 10 call options on the pound with a strike in euro.
B)buy 8 put options on the euro with a strike in pounds.
C)buying 10 call options on the pound with a strike in euro or buying 8 put options on the euro with a strike in pounds will both work.
D)none of the options

Question

Quizplus · Accepted Answer

To hedge a £100,000 payable, the firm can either buy call options on the pound (since it will need more pounds if the pound appreciates) or buy put options on the euro (since it will need fewer euros if the euro depreciates). Both strategies effectively lock in a rate for converting euros to pounds, covering the exposure. The specific numbers of options (10 for calls, 8 for puts) are derived from the contract sizes and the amount to be hedged (£100,000), ensuring full coverage of the payable amount.

Suppose That the Exchange Rate Is €1