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Answer: ABC would be better off by entering into a forward contract if EUR depreciates against USD by an amount significantly larger than USD 0.03 per EUR 1.
The correct answer is D. The rationale behind this choice is based on the comparison between the payoffs from a forward contract and a call option for hedging a net receivable in foreign currency. When the foreign exchange (FX) rate is below USD 1.07 for EUR 1, the profit from selling a call option is capped at the premium received for the option. However, with a forward contract, the profit can be larger if the FX rate is favorable. Option A is incorrect because if the FX rate falls below USD 1.07, the profit from the option is limited to the premium, whereas the forward contract could yield a higher profit if the rate is advantageous. Option B is incorrect because the strike price for the call option is USD 1.07, which is less than the forward rate of USD 1.10. Additionally, the company receives a premium for the option, making this option less favorable unless the premium is less than the difference between the forward rate and the strike price (i.e., less than 0.03). Option C is also incorrect because if the FX rate is between USD 1.07 and USD 1.10, the company would still be at a premium with the forward contract, but it would have to pay for the option. Depending on the premium received from the option, either strategy could be more beneficial. In summary, the company would be better off entering into a forward contract if the EUR depreciates against the USD by an amount significantly larger than USD 0.03 per EUR 1, as this would maximize the potential profit from the favorable exchange rate movement.
Author: LeetQuiz Editorial Team
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A portfolio manager at a company is assessing the firm's foreign exchange (FX) exposures as of June 1, 2023, and intends to hedge a net receivable of EUR 5,000,000 that is expected on December 1, 2023. On the review date, the spot rate for the Euro (EUR) is USD 1.07 per EUR 1, and the 6-month forward rate stands at USD 1.10 per EUR 1. The manager is evaluating two hedging strategies:
Which of the following statements most accurately reflects the manager's considerations?
A
ABC would be better off by selling an option contract regardless of how large the change in the FX rate is and in which direction EUR moves relative to USD.
B
ABC would be better off by entering into a forward contract if EUR appreciates against UsD by an amount significantly larger than UsD 0.03 per EUR 1 and the calloption premium ismore than 0.03.
C
ABC would be better off by entering into a forward contract if EUR appreciates against USD by less than USD 0.03 per EUR 1.
D
ABC would be better off by entering into a forward contract if EUR depreciates against USD by an amount significantly larger than USD 0.03 per EUR 1.