Assume that today is March 7, and, as the newest hire for Goldman Sachs, you must advise a client on the costs and benefits of hedging a transaction with options. Your client (a small U.S. exporting firm) is scheduled to receive a payment of €6,250,000 on April 20, 44 days in the future. Assume that your client can borrow and lend at a 6% p.a. U.S. interest rate.
a. Describe the nature of your client’s foreign exchange risk.
b. Use the appropriate American option with an April maturity and a strike price of 129¢/€ to determine the dollar cost today of hedging the transaction with an option strategy. The cost of the call option is 3.93¢/€, and the cost of the put option is 1.58¢/€.
c. What is the minimum dollar revenue your client will receive in April? Remember to take account of the opportunity cost of doing the option hedge.
d. Determine the value of the spot rate ($/€) in April that would make your client indifferent ex post to having done the option transaction or a forward hedge. The forward rate for delivery on April 20 is $1.30/€.