Explanation:
The CFO's analysis is incorrect because there is unlimited downside risk. The option premium received is a fixed amount, and if the EUR depreciates sharply, the value of the underlying receivable goes down as well. If instead the EUR moves in a narrow range, that would be good, but there is no guarantee of course that this will occur.
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Company XYZ, a US-based firm, holds net trade receivables of EUR 5,000,000 from a German export contract, due to be received on December 1, 2019. On June 1, 2019, the spot exchange rate is USD 1.19/EUR, and the six-month forward rate is USD 1.17/EUR. To hedge this exposure, the CFO is considering two alternatives:
In assessing the potential hedging strategy, the CFO argues that selling the call option is preferable to using a forward contract. Their reasoning is:
What can be concluded about the CFO’s analysis of these two hedging strategies?
A
The CFO's analysis is correct and the company is better off whichever way the EUR rate goes.
B
The CFO's analysis is not correct and the company will suffer if the EUR appreciates sharply against the USD.
C
The CFO's analysis is not correct and the company will suffer if the EUR moves within a narrow range.
D
The CFO's analysis is not correct and the company will suffer if the EUR depreciates sharply against the USD.
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