Question 4

Assume that today is June 30. You have been asked to help a UK client who is scheduled to
pay $US3,000,000 on September 30, 92 days into the future. Assume that your client can
borrow and lend pounds at 5% per annum. [Assume that in the UK, interest calculations are
made on the basis of a 365 day year.]

(a) Describe the nature of your client’s transaction exchange risk. (2 Marks)

(b) What is the option cost for a September 30 maturity with a strike price of STG0.70/USD1
to hedge the transaction? The option premiums per 100 dollars are STG1.75 for calls and
STG2.45 for puts. (2 Marks)

(c) How would increasing the time to maturity of the above option affect the foreign
currency option value? (2 Marks)

(d) What is the maximum STG cost (including the accumulated cost of the premium) that
your client will experience in September? (3 Marks)