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 a U.K. firm to hedge a €100,000 payable,
A) buy 10 call options on the euro with a strike in pounds sterling.
B) buy 8 put options on the pound with a strike in euro.
C) sell 10 call options on the euro with a strike in pounds sterling.
D) sell 8 put options on the pound with a strike in euro.
E) both a and b
F) both c and d

Question

Quizplus · Accepted Answer

The correct answer is to buy 10 call options on the euro with a strike in pounds sterling and buy 8 put options on the pound with a strike in euro. This will hedge the €100,000 payable because the call options will give the firm the right to buy euros at a fixed rate of £0.80 = €1.00, and the put options will give the firm the right to sell pounds at a fixed rate of €1.25 = £1.00.

Suppose That the Exchange Rate Is €1