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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against forex risk

A UK company must pay USD 1,000,000 in three months and buys USD call options (OTC) at a strike of $1.2500/£ equivalent, expressed as the right to buy USD at £0.8000 per $1. The premium is £0.0200 per $1, payable now. The three-month sterling interest rate is 2% for the period. At expiry the spot rate is £0.8400 per $1. What is the total sterling cost of settling the payable, including the premium at its future value?

The total cost is £820,400. The option is exercised because spot (£0.84) is worse than the strike (£0.80), giving £800,000. The £20,000 premium paid today grows by 2% to £20,400, so the all-in cost is £820,400.

  1. A£820,400Correct
  2. B£800,000
  3. C£820,000
  4. D£860,400

Explanation

Spot £0.84 exceeds strike £0.80, so the option is exercised: cost 1,000,000 x 0.80 = £800,000. Premium = 1,000,000 x 0.02 = £20,000, future value x 1.02 = £20,400. Total = £820,400. £820,000 ignores the interest on the premium; £860,400 wrongly uses spot.

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