In April 2012, an FI bought a one-month sterling T-bill paying £100 million in May 2012. 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 foreign exchange risk the FI is facing is the depreciation of the pound sterling. To hedge against this risk, the FI should purchase put options. A put option gives the buyer the right to sell the underlying currency at a specified exercise price. In this case, the FI can purchase put options on sterling with an exercise price of $1.60/£1. This will give them the right to sell their sterling at that price if the exchange rate falls below $1.60/£1. The size of the options contract should be based on the size of their exposure, which in this case is £100 million. The cost of the options is not given, but the premium per £ for the futures options is lower than that for the standalone options. Therefore, it might be more cost-effective to use the futures options to hedge the currency risk.

In April 2012, an FI Bought a One-Month Sterling T-Bill