You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.

Required:
a. Calculate your expected dollar cost of buying $F5,000 if you choose to hedge by a call option on SF.
b. Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.
c. At what future spot exchange rate will you be indifferent between the forward and option market hedges?
d. Illustrate the future dollar cost of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

Answer:

A. 3403.75 dollars

B. 3150

C. 0.579

D. Is an attachment

Explanation:

A. We first find the premium cost

= 0.05x5000 x 1+0.06/4

= 250x1.015

= 253.75

From here we find expected dollar cost

= Exchange rate x units + premium

= 0.63x5000+253.75

= 3,403.75 dollars

B. Forward rate = 0.63

Total cost of dollar

= 0.63x5000

= 3150

C. The investor would be indifferent at 0.579

Forward rate = unit * future + premium

3150 = 5000 * future + 253.75

3150-253.75 = 5000*future

We solve and divide through by 5000

Future = 0.579

D is in the attachment

The expected dollar cost of buying $F5,000 through the call option is $3403.75.

The first thing to do is to calculate the premium cost. This will be:

= (5% × 5000) × (1 + 6%/4)

= (0.05 × 5000) × (1 + 0.06/4)

= 250 × 1.015

= 253.75

The expected dollar cost will be:

= Exchange rate × Number of units + Call premium cost

= 0.63 × 5000 + 253.75

= 3403.75

The future dollar cost of meeting this SF obligation will be calculated thus:

= Forward rate × Number of units

= 0.63 × 5000

= $3150

The future spot exchange rate that the person will be indifferent will be:

= (3150 - 253.75) / 5000

= $0.579

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