ANSWER KEY TO PROBLEM SET 3

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ANSWER KEY TO PROBLEM SET 3

• QUESTION 1
• The firm should use a DM put option given that it
  will be selling DM and is concerned that the DM
  may depreciate
• The firm must purchase DM 11.5M/DM 62,500 184
  contracts
• Each option costs DM 62,500 ? .0025/DM
  156.25 for a total cost of 184 ? 156.25
  28,750

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PAYOFFS FROM OPTIONS HEDGE
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• QUESTION 2
• Part A is same as example in class
• Part B, we need to recalculate the futures price
  on October 26
• The firm has gone long on DM futures
• In the first case, since spot is same as forward
  on October 26, net gain is zero
• Lets examine the other two cases

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• If S .6255/DM on October 26, then December DM
  futures price is
• Futt,T (.6255/DM) ? (1.0624/1.0404)(51/365)
  .6273/DM
• Profit on long futures position is .6273 -
  .6107 .0166
• Unexpected profit on short DM spot is
• - (.6255 - .6089) - .0166

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• Net gain is zero
• If S .5744/DM, then December DM futures price
  on October 26 is
• Futt,T (..5744/DM) ? (1.0624/1.0404)(51/365)
  .5790/DM
• Profit on long futures position is ..5790 -
  .6107 - .0315
• Unexpected profit on short DM spot is
• - (.5744 - .6089) .0315

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• QUESTION 5
• The total payment the dealer has to make is SFr
  225 ? 100,000 SFr 22.5 million
• Using futures to hedge, the dealer will go long
  on DM futures
• The dealer needs SFr 22.5 m/SFr 125,000 180
  contracts
• Lets examine the payoffs

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• It is better to use forward hedging in this
  scenario
• QUESTION 6
• In this case, the firm is receiving C 5 million
• The firm will have to go short on futures
• The firm needs C 5 m/C 100,000 50 contracts
• Lets examine the payoffs

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• It is better to use forward
• QUESTION 7
• In this case, XYZ has a long position
• It will either go short on DM forward or futures
  or buy DM put options
• Lets examine the payoffs from the different
  hedging choices

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• First option is to go short on futures
• In this case, the firm will receive DM 10 m ?
  .6279/DM 6,279,000
• Whether we gain or lose depends on how much Dm
  strengthens, if futures expire when we receive
  payment, and if interest rates change in the
  meantime

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• If we go with 80 DM put options, then cost is DM
  125,000 ? 80 ? .0128/DM 128,000
• If the firm determines that it wants to exercise
  the option, it will receive 6,172,000
• If the DM appreciates, it will go to the spot
• The break-even spot rate is .6428/DM (given the
  cost of the puts this calculation compares a
  case of exercising an option and getting
  6,300,000 with a case of not exercising the
  option and having a net amount of 6,300,000)

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• If spot rate is above this rate (DM depreciates)
  then firm will use spot market
• A forward contract will lock in a rate
• We need to compare the rate on forward contract
  with the outcomes of the other hedges
• QUESTION 8
• Cost is 6,250,000/100 ? 0.0126 787.50