If Mr. Rothschild elects to use an option hedge, exactly how should he do it? Should he buy a call, buy a put, sell a call or sell a put?
There are many hedging strategies that could be opted by Mr. Rothschild, for instance, he could go for a forward hedge, futures hedge or an options contract. If we talk about the options hedge then there are call options and put options and Dozier will have to decide now that whether the options would be beneficial for the company or not. The total contract value stands at 1175000 and the company has received a deposit of around 10% of the total contract value which stands at 170140.
The remaining payment of 1057500 pounds is receivable by the company and this is the amount which is exposed to the exchange rate risk. If the company wants to hedge the risk against the movements in the exchange risk, then the company could purchase the put contracts. These put contracts will save the company if the receivables of the company lose value against the USD. This would happen when the strike price remains above than the exchange rate. This strategy would only work if Dozier purchases the right quantity of the put contracts and at the right price.
Along with this, Dozier will have to sell the call options. These would be sold at the USD/GBP exchange rate. The minimum profit of the company would be increased for the company by gaining profit from the sale of these options. However, the upside potential of earning the profit for the company would be limited. This means that the maximum profit that could be earned by the company would be limited but the management could earn above the lowest minimum profit. Since the time frame of the contract is short which is3 months therefore, it is advisable for the company to use the call options and sell them to increase the overall profits.
Which option or options from Exhibit 2 would you use? Why?
First of all, the company will have to decide the number of the contracts that would be bought by the company, the expiration date and the strike price of the options. It is shown in exhibit 2 that the option contracts are sold in the bundles of 12500 pound each. In order to buy the put options, the company will have to buy those as close to the exchange rate as possible. Looking at the table this rate would be around 1.45 per pound which is the closest strike price and does not cross the exchange rate. The latest expiration date for this option would be March. Finally, the total premium cost of these put options would be 0.044. A total of 85 contracts (round off) would be needed in order to hedge this contract………………..
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