Premium Ltd, a South African-based MNC has US$200,000 receivables in 6 months' time and would like to hedge the value of the dollar receipts with currency options. The current spot exchange rate is R10 per U.S. dollar. The risk manager of Premium Ltd decided to use currency option contracts to hedge against the possible future depreciation of U.S. dollars. OTC options (exercise exchange rate at R9 per U.S. dollar) can be negotiated with Premium Ltd's banker at an upfront premium of R1 per U.S. dollar transaction. 

 

(a) Identify the relevant currency option strategy for Premium Ltd and graphically demonstrate the profit/loss profile per U.S. dollar for the strategy.

 

(b) Calculate the profits/Loss in South African rands of the relevant currency option strategy (compared to the current spot rate today) if the spot exchange rates in 6 months are: (10) * R5 per U.S. dollar; * R6 per U.S. dollar; * R7 per U.S. dollar; * R14 per U.S. dollar; and * R16 per U.S. dollar.

 

 (c) Explain the pros and cons of hedging foreign exchange exposure using currency option strategy compared to currency forward contracts.