Hedging with Straddles (See the chapter appendix.) Brooks, Inc., imports wood from Morocco.

The Moroccan exporter invoices in Moroccan dirham.

The current exchange rate of the dirham is $.10. Brooks just purchased wood for 2 million dirham and should pay for the wood in 3 months. It is also possible that Brooks will receive 4 million dirham in 3 months from the sale of refinished wood in Morocco. Brooks is currently in negotiations with a Moroccan importer about the refinished wood. If the negotiations are successful, Brooks will receive the 4 million dirham in 3 months, for a net cash inflow of 2 million dirham.

The following option information is available:

■ Call option premium on Moroccan dirham = $.003.

■ Put option premium on Moroccan dirham = $.002.

■ Call and put option strike price = $.098.

■ One option contract represents 500,000 dirham.

a. Describe how Brooks 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 $.098. In the second scenario, the dirham depreciates to $.08. In the third scenario, the dirham appreciates to $.11. 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.