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24 July, 08:29

If the break-even exchange rate for the Currency Options Contract is 1.46 $/BP, and you believe the exchange rate at the time of the payment would be 1.43 $/BP, should you sign the contract?

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  1. 24 July, 08:33
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    Complete question

    You are US company, 500,000 BP (British Pound) payable to UK in one year. Answer in terms of US$.

    Information for Forward Contract:

    Forward exchange rate (one yr) : 1.54 $/BP

    Information for Money Market Instruments (MMI):

    Current exchange rate: 1.50 $/BP

    Investment return at Aerion Fund Management (in UK) : 4% annual

    Interest rate of borrowing from Bank of America (in USA) : 2% annual

    Information you need for Currency Options Contract:

    Options premium: 0.015 $/BP

    Interest rate of borrowing from Bank of America (USA) : 2% annual

    Allowed to exercise options at 1.54 $/BP

    If the break-even exchange rate for the Currency Options Contract is 1.46 $/BP, and you believe the exchange rate at the time of the payment would be 1.43 $/BP, should you sign the contract?

    Explanation:

    No, I will not sign the contract because the break-even exchange rate itself is 1.46 $/BP and it would mean that exchange rate below this price will give gains to the company and above this price would be a losing proposition. Since on the due date, exchange rate in the market will be lower than the options break-even price, company will buy the BP from the market and pay its obligation instead of exercising option at higher rate.
  2. 24 July, 08:52
    0
    Yes, I will sign the contract.

    Explanation:

    The break-even exchange rate for the currency options contract is $1.46/BP and the exchange rate at the time of the payment will be $1.43/BP which means a reduction of $0.03 as future value. Since the contract was not signed with the inflationary rate, the receiver is at advantage while the lender is at a loss.
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