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CA Final · Advanced Financial Management · Foreign Exchange Exposure and Risk Management

Kaveri Industries must pay GBP 100,000 in two months. It buys a GBP call option with strike Rs 104.00 per GBP at a premium of Rs 1.50 per GBP. Ignoring time value of the premium, at what spot rate at expiry does the option strategy cost the same as leaving the exposure unhedged?

The buyer of a call pays strike plus premium when exercised, so effective cost is 104.00 + 1.50 = Rs 105.50 per pound. At that spot rate the unhedged cost equals the hedged cost, so Rs 105.50 is the breakeven.

  1. ARs 102.50
  2. BRs 105.50Correct
  3. CRs 104.00
  4. DRs 106.00

Explanation

Effective cost with the call is capped at strike plus premium = 104.00 + 1.50 = Rs 105.50 per GBP. Above a spot of 105.50 the hedge beats being unhedged; at exactly 105.50 both cost the same, since the call is exercised and cost equals 105.50. Rs 104.00 ignores the premium, a common error. Rs 102.50 subtracts the premium instead of adding it.

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