Assume that today is September 12. You have been asked to help a British client who is scheduled to pay :1,500,000 on December 12, 91 days in the future. Assume that your client can borrow and lend pounds at 5% p.a.
a. Describe the nature of your client's transaction exchange risk.
b. What is the option cost for a December maturity and a strike price of £0.72 >: to hedge the a. If an August pound option with a strike price of 175¢>£ costs 4.5¢>£ per pound for the call and 4¢>£ for the put, what is the minimum effective exchange rate in August that you will pay? Over what range of future exchange rates will this price be achieved?
b. How much must the pound appreciate before your speculative option strategy ends up costing you more than the forward rate?