Hedging with a bull spread (refer to Chapter 11). Evar Imports Ltd buys chocolate from Switzerland and resells it in the UK. It just purchased chocolate invoiced at CHF62,500. Payment for the invoice is due in 30 days.

Assume that the current exchange rate of the Swiss franc is £0.49. Also assume that three call options for the franc are available. The first option has a strike price of £0.49 and a premium of £0.02; the second option has a strike price of £0.51 and a premium of £0.005; the third option has a strike price of £0.53 and a premium of £0.004. Evar Imports is concerned about a modest appreciation in the Swiss franc. (Refer to Appendix 12 in this chapter.)

a Describe how Evar Imports could construct a bull spread using the first two options. What is the cost of this hedge? When is this hedge most effective? When is it least effective?

b Describe how Evar Imports could construct a bull spread using the first option and the third option. What is the cost of this hedge? When is this hedge most effective? When is it least effective?

c Given your answers to parts

(a) and (b), what is the trade-off involved in constructing a bull spread using call options with a higher exercise price?