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Foreign exchange risk

Question 14

Options

A UK importer is due to pay €100m in 6 months’ time and the financial manager
is concerned about exchange rate fluctuations between now and the payment
date affecting the value of £ that will be needed to complete the transaction.

The company’s bank has offered a 6 month call option on €100m at an exercise
price of €1.155 with a premium of £20,000.

Show the total payment if the exchange rate moves to either €1.150 = £1 or to
€1.160 = £1

£ paid at €1.155 = £1 = €100m/1.155 = £86,580,087 if option exercised

£ paid at €1.150 = £1 = €100m/1.150 = £86,956,522

This is more than if the option is exercised, so the company would choose to
exercise the option and would pay a total (including the premium of £20,000
which is paid regardless of whether the option is exercised or not) of
£86,600,087

£ paid at €1.160 = £1 = €100m/1.160 = £86,206,897

This is a lower amount than from exercising the option so the option would be
allowed to lapse and the total paid (again, including the premium) would be
£86,226,897

Illustrations and further practice

Now work through illustration 5 from Chapter 13.

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