Adapted from Fundamentals of Futures and Options Markets, 6th ed., John C. Hull.
Chapter 1 AD 1: Consider the situation described in Example 1.1 on page 11. This example provides a description of hedging a foreign currency exposure with forward contracts.
Q1. Consider the initial unhedged position. If the £ strengthens relative to the $, which company will record a loss on their foreign currency exposure, Importco or Exportco?
Q2. Consider the initial unhedged position. If the £ weakens relative to the $, which company will record a loss on their foreign currency exposure, Importco or Exportco?
Q3. Example 1.1 states that Importco should purchase £10 million in the forward market. Is this position in the forward contract a long position or a short position? What happens to the value of the forward position if the £ strengthens? What happens to the value of the forward position if the £ weakens?
Q4. Example 1.1 states that Exportco should sell £30 million in the forward market. Is this position in the forward contract a long position or a short position? What happens to the value of the forward position if the £ strengthens? What happens to the value of the forward position if the £ weakens?
Q5. Discuss how foreign currency options can be used so that Importco is guaranteed that its exchange rate will be less than 1.8800. To do this, answer the following: will Importco use a put or a call? Will it be long or short the option? What strike price should be chosen? How would your answer change if transaction costs and/or option premia were considered? What happens to the value of the option position if the £ strengthens? What happens to the value of the option position if the £ weakens?
Q6. Discuss how foreign currency options can be used so that Exportco is guaranteed that its exchange rate will be at least 1.8500. To do this, answer the following: will Exportco use a put or a call? Will it be long or short the option? What strike price should be chosen? How would your answer change if transaction costs and/or option premia were considered? What happens to the value of the option position if the £ strengthens? What happens to the value of the option position if the £ weakens?
Q7. What are the major differences between hedging with forward contracts and hedging with option contracts? Which provide symmetric payoffs? Which do not? Which incur up-front costs? Which do not?