Currency Options: Short Answer Questions The following short answer questions ask you to explain specific uses of currency options.
Required
a. The Footlocker retail chain in the U.S. imports soccer shoes from the U.K. based on prices in British pounds and makes payments one month after delivery. To hedge against potential losses caused by a weakening dollar, Footlocker could buy call options to purchase pounds with dollars or buy put options to sell dollars for pounds. Explain whether these alternatives are likely to have the same economic effect on Footlocker.
b. Another strategy for Footlocker in part a involves both buying call options to purchase pounds with dollars and writing put options to sell dollars for pounds at the same exercise price. Explain whether this strategy is likely to have the same economic effect on Footlocker.
c. KBR, Inc., a U.S construction firm, is building a stadium in Italy. Costs are incurred in euros (€) but Italian suppliers require payment in U.S. dollars at the prevailing exchange rate. Explain whether KBR, Inc. can hedge against exchange rate risk by purchasing call options to purchase euros with dollars.
d. Higher interest rates in Europe led Citibank, a subsidiary of Citigroup, to purchase and invest €20,000,000 in a euro-denominated certificate of deposit paying 4 percent per annum. The bank's financial wizard wants to write 12-month calls at the money to protect the dollar equivalent of the €800,000 of interest due in 12 months. If the premium is $0.1111/€ and the dollar strengthens by 7 percent in 12 months, use calculations to explain whether writing the calls will increase Citibank's return.
e. IBM borrowed €2,000,000 from a German bank, taking advantage of the low 3.5 percent interest rate in Germany, and converted the euros to dollars when the exchange rate was $1.40/€. Because the euro may strengthen over the next year, IBM hedges the first year's interest payment by purchasing at-the-money calls for €70,000 when the exchange rate is $1.43/€; the premium is $0.03125/€. If at the end of the first year the exchange rate is $1.45/€, explain whether purchasing the calls increased IBM's financing cost compared with not hedging.