38 Hedging with straddles. (See the Appendix B.)

Bach GmbH (a German company) imports wood from Morocco. The Moroccan exporter invoices in Moroccan dirham. The current exchange rate of the dirham is 0.10 euro. Bach has just purchased wood for 2 million dirham and should pay for the wood in three months. It is also possible that Bach will receive 4 million dirham in three months from the sale of refinished wood in Morocco. Bach is currently in negotiations with a Moroccan importer about the refinished wood. If the negotiations are successful, Bach will receive the 4 million dirham in three months, for a net cash outflow of 2 million dirham.

The following option information is available:

l Call option premium on Moroccan dirham ¼

0.003 euro.

l Put option premium on Moroccan dirham ¼

0.002 euro.

l Call and put option strike price ¼ 0.098 euro.

l One option contract represents 500 000 dirham.

a Describe how Bach could use a straddle to hedge its possible positions in dirham.

b Consider three scenarios. In the first scenario, the dirham’s spot rate at option expiration is equal to the exercise price of 0.98 euro. In the second scenario, the dirham depreciates to 0.08 euro. In the third scenario, the dirham appreciates to 0.11 euro. For each scenario, consider both the case when the negotiations are successful and the case when the negotiations are not successful.

Assess the effectiveness of the long straddle in each of these situations by comparing it to a strategy of using long call options to hedge.