Suppose that your Italian firm expects to make a payment of 100 million in six months for imports from Great Britain (GB). As the chief financial officer (CFO), you need to decide whether you should hedge against exchange rate risks in the next six months. If you decide to hedge against exchange rate risks in the next six months, you would use either the currency forward or currency option market. You are quoted the following spot rate, forward rate and options strike prices and premiums.

Todays spot rate 6 month Forward rate

1.1440/ 1.1000/

Options Strike Price Premium

Put option on 1.1500/ 1,000,000

Call option on 1.1400/ 1,000,000

Explain briefly three factors that you consider in deciding whether your company should or should not hedge against exchange rate risks. [10%]

Explain how you can use the currency option market and currency forward market to hedge against exchange rate risks. Be sure to discuss the specific risks being hedged, and three differences (maturity and settlement of contract, pricing and margin/collateral requirement, counterparty risks, and potential profits/losses) between a currency option and currency forward market. [15%]

If the spot rate in 6 month is 1.2000/, explain the potential gains or losses from using the currency option market. [5%]

If the spot rate in 6 month is 1.0000/, explain the potential gains or losses from using the currency forward market. [5%]