Charles has a problem. His boss thinks that options are a form of gambling. The company he works for exports to European markets, which require euro invoicing.
The market is cutthroat, and sales are made on the basis of competitive bidding.
The average-size bid is €2.5 million. Firm offers (which means that if the bid is accepted, the company must deliver) are made each month. Normally, winning bids are announced one month after the offer is made. Delivery is made one month after acceptance of the offer. Payment terms are one month after shipment. This means that payment on successful bids normally is ninety days after the bid is submitted.
The company's experience has been that two out of three bids are successful.
Charles recommended that the company buy one-month or three-month put options on the euro from its bank at the time a bid was made. However, his boss thought they should sell euros forward to hedge the exposure. Besides taking the view that options are speculative, Charles's boss disliked the idea of paying up front for something they might never need. Finally, he considered them much more expensive than a forward contract.
The current spot rate is $0.8870 per €1. The three-month forward rate is $0.8855 per €1. A one-month put option on the euro with the strike price set at $0.8850 would cost $0.0095 per €1; a three-month put option on the euro with a strike price set at $0.8850 per €1 would cost $0.0210 per €1.
Using the average-size bid of €2.5 million to illustrate, how should Charles's company hedge its euro risk? Prepare some arguments to support his recommendation, unless you believe him to be mistaken. In the latter case, indicate why.