Factor14 plc is a British electronics manufacturer, which has various suppliers and customers across Europe. The company is expecting to receive €1,500,000 EUR in six months’ time (180 days) for a shipment of parts it has sold and wants to hedge against a decline in value of the Euro against the pound (GBP).
At present the following market prices prevail: Spot price EUR/GBP: EUR 1.00 = GBP 0.87 6-month (180 day) money market rates: 1.2% per annum to borrow or lend GBP 0.7% per annum to borrow or lend EUR Currency options on EUR/GBP with 180 days to expiration, a strike price of EUR 1.00 = GBP 0.87 and a contract size of 1 euro cost as follows: Euro put premium: GBP 0.11 (i.e. 11 pence per EUR) Euro call premium: GBP 0.09 (i.e. 9 pence per EUR)
Explain how the company could, alternatively, hedge its foreign currency risk using the options set out above. Using pay-off diagrams for the total payoff of the strategy, show how the recommended strategy would perform given exchange rates in 180 days’ time from EUR 1 = GBP 0.6 to EUR 1 = GBP 1.1.