Crown Co. is expecting to receive 100,000 British pounds in one year. Crown expects the spot rate of 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% 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

Quizplus · Accepted Answer

SOLUTION:
There are only two feasible choices for hedging in these circumstances: selling pounds forward or buying a put option.
Sell pounds forward:
One-year forward rate $= \$ 1.51 \times ( 1 + .0265 ) = \$ 1.55$
Dollars received $= 100,000 \times \$ 1.55 = \$ 155,000$
Buy put option:
Amount received per unit $= \$ 1.54 - \$ .03 = \$ 1.51$
Total amount of receivables in U.S. $\$ = 100,000 \times \$ 1.51 = \$ 151,000$

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