Question

Suppose I own a soccer ball producing firm in London England and I am selling 10,000 soccer balls in 90 days to the US for a price of $140,000. The current spot rate is $ 1.5 / £. We are going to use the option market to hedge against unfavorable exchange rate movements.

You must show all work for full credit.

a) (5 points) Considering this transaction only, what do we mean by 'unfavorable' exchange rate movements?

b) (5 points) Suppose it costs me £ 85,000 to produce and transport the soccer balls, if the exchange rate in 90 days is the same as the current spot ($1.5/£), what is my profit in terms of British pounds (£)?

Suppose that there are options available that give me the option to exchange $ for £ at an exchange rate of $1.5 per £ 90 days from now. Suppose these options collectively cost you £ 5000. We are going to consider two separate scenarios:

Scenario #1: In 90 days, the spot exchange rate is $ 1.6/£.

Scenario #2: In 90 days, the spot exchange rate is $ 1.4/£.

Reminder: The options give you the right, not the obligation to exchange your $140,000 at $1.5 per £.

c) (5 points) Given Scenario #1, what is your total profit / loss from selling the soccer balls?

d) (5 points) Given Scenario #2, what is your profit / loss from selling the soccer balls?

Answer 1

a) When we transact in International market, we often hear the term called " unfavourable exchange rate movements". This exchange rate movement basically means the change in the exchange rate between two coutries because of depreciation or appreciation of one currency in respect of the other one resulting in gain/ loss of either party.

b) in the given question the Seller is from London having incurred a cost of £85,000 and will be receiving from US customer $140,000.

The exchange rate is $1.5=£ 1

after 90 days London seller will receive= £ (1 x 1,40,000)/1.5 =93,333.33

profit =£ (93,333 - 85,000) =£ 8,333