Question

3M has signed a contract with the German government in order to supply 3 millions of facemasks worth 10 million Euros. The German government will pay this amount in 120 days. 3M has decided to buy an option contract with a bank in order to hedge any risk on the value of the € versus the $. Strike price agreed with bank is 0.9 $/€ and premium on the option is 0.05$/€. a) What type of option, call or put, is better for 3M to hedge the risk on this operation? Why? b) What is the hedged value of 3M if it decides to exercise the option? c) At what spot rate (t = 120 days) does it make sense for 3M to exercise the option? d) How much is the breakeven point (BEP)? e) Could you explain if you would exercise or not the option and the profit/loss situation in the following scenarios of the spot rate 120 days: 0.8$/€ and 1.01$/€.

Answer 1

(a) Put option is better for 3M to hegde the risk of operation.

(b) Hedged value = $8.5 million

(c) At any spot rate less than $0.9/€

(d) Breakeven point = $0.85/€

(e) If spot is 0.8$/€, exercise profit

If spot is 1.01$/€., don't exercise profit

Step-by-step explanation:

a.

the risk is that euro will depreciate against dollar hence buy put option on euro as put profits when underlying falls.

Hence, Put option is better for 3M to hegde the risk of operation.

b.

Hedged value = size*(strike-premium)

=10*(0.9-0.05)

=8.5 million dollars

c.

At any spot rate less than $0.9/€, it makes sense for 3M to exercise the option.

d.

Breakeven Point of hedging is where 3M has no profit and no loss after adjusting its premium cost.

Break even Point : $0.9- $0.05 = $0.85/€

At 0.85 $/€ 3M will have not profit no loss on hedging its risk

e.

If spot is 0.8, exercise..profit=10*10^6*(0.9-0.8-0.05) = 500000

If spot is 1.01, don't exercise..profit=10*10^6*(-0.05) = -500000 i.e., loss of 500000