Question

You will receive 525,000 euros on June 20 (in 90 days) and want to hedge your currency exchange risk exposure with either Futures Contracts or Options. The current exchange rate is $1.06 per euro. The 90 day forward rate is $1.07 per euro and that is the exchange rate that both Futures and Options are using for their 90 day contracts. You, on the other hand, believe with the current banking system problems, the actual 90 day spot rate may have a significant variance from the expected 90 day rate. The variance could be in either direction. You want to test the outcome of both a positive and negative variance using a Futures Contract and an Options Contract. You select a high exchange rate of $1.13 and a low exchange rate of $1.04 as your test exchange rates. The cost of one option is $900.

Answer 1

To hedge currency exchange risk exposure, you can use Futures Contracts or Options. Futures Contracts are used to hedge against negative variations in the exchange rate, while Options Contracts give you the right to buy or sell currency at a predetermined price to hedge against negative variations.

Step-by-step explanation:

Hedging currency exchange risk exposure can be done using either Futures Contracts or Options. In this case, you want to test the outcome of both a positive and negative variance using these financial instruments.

A Futures Contract is a standardized contract that obligates the buyer to purchase or the seller to sell a specified amount of a currency at a predetermined price and future date. By entering into a Futures Contract at the expected 90-day rate of $1.07 per euro, you can hedge against a negative variance where the spot rate is lower than expected.

On the other hand, an Options Contract gives you the right, but not the obligation, to buy or sell a specific amount of currency at a predetermined price within a specified period. By purchasing a put option with a strike price of $1.04, you can hedge against a negative variance where the spot rate is significantly lower. The cost of the put option is $900.