A French firm is required to make a payment of EUR 1500000 t

A French firm is required to make a payment of EUR 1500000 to a supplier in 150 days.

Describe how the firm can hedge the transaction risk associated with the payment using a currency option.

Solution

Hedging with currency options

In the present case the French Firm has EUR 15,00,000/- payable to a supplier in 150 days. Thus, the firm is afraid of EUR rising against franc. It is assumed that the two currencies involved in this transaction are franc and EUR. In the present case, the firm knows the amount of EUR payable but it is uncertain of the Franc outflow at the end of 150 days. If EUR rises against franc, the franc outflow will rise.

Thus, to hedge the same, the firm must enter into a currency option. It should buy a call option on EUR. The call option on EUR gives the buyer the right but not the obligation to buy EUR on maturity at a predetermined strike price (maturity is after 150 days or closest to it) if the prevailing exchange rate after 150 days is more than the determined strike price. Thus we see that the firm is betting that the exchange rate on maturity to go up. If it goes up, the firm will buy at the predetermined strike price which will obviously be lower than the then prevailing exchange rate. In this way the firm gains.

Another important point in currency option is that the buyer of the option has to pay a premium to buy the right to buy the currency i.e 15,00,000/-EUR or abstain from buying if exchange rate does not exceed the strike price. Therefore, we see that the premium is an outflow. So the firm will want that the exchange rate on maturity to exceed the aggregate of the strike price and the premium paid.

In case the exchange rate falls than the agreed upon strike price the firm will not execute the transaction as it has no obligation to exercise the option.