Hedging decisions by the Sports Exports Company

Jim Logan, owner of the Sports Exports Company, will be receiving 10,000 British pounds one month from now as payment for exports produced and sent by his company. Logan is concerned about his exposure because he believes that there are two possible scenarios: (1) the pound will depreciate by 3 per cent over the next month, or (2) the pound will appreciate by 2 per cent over the next month. There is a 70 per cent chance that (1) will occur. There is a 30 per cent chance that (2) will occur. Logan notices that the prevailing spot rate of the pound is A$1.65, and the one-month forward rate is A$1.645.

Logan can purchase a put option over the counter from a securities company that has an exercise (strike) price of A$1.645, a premium of A$0.025 and an expiration date of one month from now.

a. Determine the amount of Australian dollars received by the Sports Exports Company if the receivables to be received in one month are not hedged under each of the two exchange rate scenarios.

b. Determine the amount of Australian dollars received by the Sports Exports Company if a put option is used to hedge receivables in one month under each of the two exchange rate scenarios.

c. Determine the amount of Australian dollars received by the Sports Exports Company if a forward hedge is used to hedge receivables in one month under each of the two exchange rate scenarios

d. Summarise the results of Australian dollars received based on an unhedged strategy, a put option strategy and a forward hedge strategy. Select the strategy that you prefer based on the information provided.

e. What is the break-even strike price between the put option and forward rate hedging strategy?