Sep 2013 - Q.1 and Q.6

Discussion in 'CT2' started by bluetail, Mar 20, 2014.

  1. bluetail

    bluetail Member

    Does anyone understand why the correct answer for Q1 is C?

    my reasoning is it should be D because we want to have a put option to sell euros. so if the euro weakens, we'll be able to use the put option to fix the value of our receipt in australian dollars.

    As for Q.6, it seems that the only sensible choice is A, but the logic here is not straightforward..i thought a high intrest cover as a ratio indicates the ability to generate enough cash to pay off debt i.e. it is a measure of liquidity itself.
     
    bluetail, Mar 20, 2014
    #1
  2. Simon James

    Simon James ActEd Tutor Staff Member

    Q1 using an option to hedge the transaction will offer the trader protection against adverse currency movements while retaining the ability to profit from favourable movements.

    As a recipient of Euros, a favourable currency movement would be a strengthening of the Euro (as this would increase the value of the Euros the trader receives). Using a currency future to hedge the transaction would guarantee the value of the Euros to be received but would not provide scope for any upside.

    Q6 you are right, the best answer is A - the rationale is that the company is described as being highly cash generative (hence liquidity is not an issue)
     
    Simon James, Apr 3, 2014
    #2
  3. bluetail

    bluetail Member

    i still do not understand how the trader would be able to gain from an upside thru an option. the favourable outcome for him is only if the Euro strengthens.

    however, the upside potential can be exploited only if he holds a currency option to buy australian dollars because only call options provide unlimited upside potential. that means he'll excercise his option only if the value of the australian dollar goes up i.e. the euro weakens.
    alternatively he could have bought a put option to sell euros, but then again he'll gain from holding the option only if the euro weakens. his upside gain would be limited by the option strike price which was agreed beforehand at the time of buying it.

    do they mean he'll gain from the strengthening of the euro if he chooses not to excercise a currency option? so he's protected if the euro weakens by holding an option but can gain by not excercising it if the euro is strong?
    in this case, can the question be badly worded/deliberately confusing?
     
    Last edited by a moderator: Apr 4, 2014
    bluetail, Apr 4, 2014
    #3
  4. Simon James

    Simon James ActEd Tutor Staff Member

    I think you have got it in the last paragraph.

    Let's look at an example. Say, €1=$1 now and the trader is due to receive €100 in 3 month's time.

    In 3 months,
    • if €1=$1.20 (ie euro strengthens) then the trader gets $120. This is upside.

    • If €1=$0.80 (ie euro weakens) then the trader gets $80. This is the risk we want to mitigate.

    So, we can buy an option to sell euros into dollars (or an option to buy dollars with euros) in 3 months at a strike price of say €1=$1.

    • If the euro strengthens we do not exercise the option as we want the upside, we simply let it lapse for loss of premium.
    • If the euro weakens we do exercise and get a better rate than the market rate at that time.

    If we had used a future (D) we would have locked into a known exchange rate with no possibility of upside.
     
    Simon James, Apr 5, 2014
    #4

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