A call option exists on British pounds with an exercise price of $1.60, a 90-day expiration date, and a premium of $.03 per unit. A put option exists on British pounds with an exercise price of $1.60, a 90-day expiration date, and a premium of $.02 per unit. You plan to purchase options to cover your future receivables of 700,000 pounds in 90 days. You will exercise the option in 90 days (if at all). You expect the spot rate of the pound to be $1.57 in 90 days. Determine the amount of dollars to be received, after deducting payment for the option premium.
A) $1,169,000.
B) $1,099,000.
C) $1,106,000.
D) $1,143,100.
E) $1,134,000.

Question

Quizplus · Accepted Answer

To determine the amount of dollars to be received, we need to first calculate the cost of purchasing the options:

Cost of call option = $0.03 x 700,000 = $21,000
Cost of put option = $0.02 x 700,000 = $14,000

Total cost of options = $21,000 + $14,000 = $35,000

Next, we need to determine the payoff from exercising the options:

Payoff from call option = maximum(0, spot rate - exercise price) x units
= maximum(0, $1.57 - $1.60) x 700,000
= $0 x 700,000
= $0

Payoff from put option = maximum(0, exercise price - spot rate) x units
= maximum(0, $1.60 - $1.57) x 700,000
= $0.03 x 700,000
= $21,000

Total amount of dollars received = payoff - cost of options
= $21,000 - $35,000
= -$14,000

Since the resulting amount is negative, we can conclude that the company would actually have to pay $14,000 in order to hedge its receivables, and so the best choice is C ($1,106,000).

A Call Option Exists on British Pounds with an Exercise