Hedging with a bull spread. (See the chapter appendix.) Evar Imports Ltd buys chocolate from Switzerland and resells it in the United Kingdom. It just purchased chocolate invoiced at SFr62 500. Payment for the invoice is due in 30 days. Assume that the current exchange rate of the Swiss franc is £0.49. Also assume that three call options for the franc are available. The first option has a strike price of £0.49 and a premium of £0.02; the second option has a strike price of £0.51 and a premium of £0.005; the third option has a strike price of £0.53 and a pre- mium of £0.004. Evar Imports is concerned about a modest appreciation in the Swiss franc.
a. Describe how Evar Imports could construct a bull spread using the first two options. What is the cost of this hedge? When is this hedge most effective? When is it least effective?
b. Describe how Evar Imports could construct a bull spread using the first option and the third option. What is the cost of this hedge? When is this hedge most effective? When is it least effective?
c. Given your answers to parts (a) and (b), what is the tradeoff involved in constructing a bull spread using call options with a higher exercise price?