Answers to End of Chapter 5 Questions
1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts.
ANSWER: Because currency futures contracts are standardized into small amounts, they can
be valuable for the speculator or small firm (a commercial bank’s forward contracts are more
common for larger amounts). However, the standardized format of futures forces limited
maturities and amounts.
2. Using Currency Futures.
a. How can currency futures be used by corporations?
ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign
currency would sell currency futures. U.S. corporations that desire to lock in a price at which
they can purchase a foreign currency would purchase currency futures.
b. How can currency futures be used by speculators?
ANSWER: Speculators who expect a currency to appreciate could purchase currency futures
contracts for that currency. Speculators who expect a currency to depreciate could sell
currency futures contracts for that currency.
3. Currency Options. Differentiate between a currency call option and a currency put option.
ANSWER: A currency call option provides the right to purchase a specified currency at a
specified price within a specified period of time. A currency put option provides the right to
sell a specified currency for a specified price within a specified period of time.
4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose
90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or
premium.
ANSWER: (F – S) / S
=($.098 – $.10) / $.10 × (360/90)
= –.02, or –2%, which reflects a 8% discount
5. Effects of a Forward Contract. How can a forward contract backfire?
ANSWER: If the spot rate of the foreign currency at the time of the transaction is worth less
than the forward rate that was negotiated, or is worth more than the forward rate that was
negotiated, the forward contract has backfired.
6. Hedging With Currency Options. When would a U.S. firm consider purchasing a call
option on euros for hedging? When would a U.S. firm consider purchasing a put option on
euros for hedging?
ANSWER: A call option can hedge a firm’s future payables denominated in euros. It
effectively locks in the maximum price to be paid for euros.
A put option on euros can hedge a U.S. firm’s future receivables denominated in euros. It
effectively locks in the minimum price at which it can exchange euros received.
7. Speculating With Currency Options. When should a speculator purchase a call option on
Australian dollars? When should a speculator purchase a put option on Australian dollars?
ANSWER: Speculators should purchase a call option on Australian dollars if they expect the
Australian dollar value to appreciate substantially over the period specified by the option
contract.
Speculators should purchase a put option on Australian dollars if they expect the Australian
dollar
value to depreciate substantially over the period specified by the option contract.
8. Currency Call Option Premiums. List the factors that affect currency call option premiums
and briefly explain the relationship that exists for each. Do you think an at-the-money call
option in euros has a higher or lower premium than an at-the-money call option in British
pounds (assuming the expiration date and the total dollar value represented by each option are
the same for both options)?
ANSWER: These factors are listed below:
•
The higher the existing spot rate relative to the strike price, the greater is the call option
value, other things equal.
•
The longer the period prior to the expiration date, the greater is the call option value,
other things equal.
•
The greater the variability of the currency, the greater is the call option value, other
things equal.
The at-the-money call option in euros should have a lower premium because the euro should
have less volatility than the pound.
9. Currency Put Option Premiums. List the factors that affect currency put options and briefly
explain the relationship that exists for each.
ANSWER: These factors are listed below:
•
The lower the existing spot rate relative to the strike price, the greater is the put option
value, other things equal.
•
The longer the period prior to the expiration date, the greater is the put option value, other
things equal.
•
The greater the variability of the currency, the greater is the put option value, other things
equal.
10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British
pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option
was exercised was $1.46. Assume there are 31,250 units in a British pound option. What
was Randy’s net profit on this option?
ANSWER:
Profit per unit on exercising the option = $.01
Premium paid per unit = $.02
Net profit per unit = –$.01
Net profit per option = 31,250 units × (–$.01) = –$312.50
11. Speculating with Currency Put Options. Alice Duever purchased a put option on British
pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound
option was exercised was $1.59. Assume there are 31,250 units in a British pound option.
What was Alice’s net profit on the option?
ANSWER:
Profit per unit on exercising the option = $.21
Premium paid per unit = $.04
Net profit per unit = $.17
Net profit for one option = 31,250 units × $.17 = $5,312.50
12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01
per unit. The strike price was $.76, and the spot rate at the time the option was exercised was
$.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also
assume that there are 50,000 units in a Canadian dollar option. What was Mike’s net profit
on the call option?
ANSWER:
Premium received per unit = $.01
Amount per unit received from selling C$ = $.76
Amount per unit paid when purchasing C$ = $.82
Net profit per unit = –$.05
Net Profit = 50,000 units × (–$.05) = –$2,500
13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per
unit. The strike price was $.75, and the spot rate at the time the option was exercised was
$.72. Assume Brian immediately sold off the Canadian dollars received when the option was
exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was
Brian’s net profit on the put option?
ANSWER:
Premium received per unit = $.03
Amount per unit received from selling C$ = $.72
Amount per unit paid for C$ = $.75
Net profit per unit = $0
14. Forward versus Currency Option Contracts. What are the advantages and disadvantages
to a U.S. corporation that uses currency options on euros rather than a forward contract on
euros to hedge its exposure in euros? Explain why an MNC use forward contracts to hedge
committed transactions and use currency options to hedge contracts that are anticipated but
not committed. Why might forward contracts be advantageous for committed transactions,
and currency options be advantageous for anticipated transactions?
ANSWER: A currency option on euros allows more flexibility since it does not commit one
to purchase or sell euros (as is the case with a euro futures or forward contract). Yet, it does
allow the option holder to purchase or sell euros at a locked-in price.
The disadvantage of a euro option is that the option itself is not free. One must pay a
premium for the call option, which is above and beyond the exercise price specified in the
contract at which the euro could be purchased.
An MNC may use forward contracts to hedge committed transactions because it would be
cheaper to use a forward contract (a premium would be paid on an option contract that has an
exercise price equal to the forward rate). The MNC may use currency options contracts to
hedge anticipated transactions because it has more flexibility to let the contract go
unexercised if the transaction does not occur.
