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

The best possible hedging strategy for Crown Co. would be to sell pounds forward at a rate of $1.51 and receive $155,000 (100,000 pounds x $1.51/£). This is because the forward rate is exhibiting a premium of 2.65%, meaning that the spot rate in a year would be $1.49 + (2.65% x $1.49) = $1.529. Selling pounds forward at a rate of $1.51 would therefore give Crown Co. a better exchange rate than if it waited until the spot rate in a year. The other hedging strategies would not result in a better exchange rate than selling pounds forward.

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