Question:
In view of its international operations management, Remo Ltd which is based in USA expects to make a payment of £ 50,000 to a UK supplier for raw materials in six months time. Remo Ltd wants to avoid any currency fluctuations. As such the Finance Director proposes to use a currency forwards in view to manage this transaction.
The forward rate offered by the bank is $1.601. The spot exchange rate is $1.781/ £ after six months.
Required
(i) What is the payment to be made if Remo Ltd enters the forward contract with the bank?
(ii). In the case above, which counterparty bears the credit risk? Justify your answer.
(iii) Outline in detail the advantages of using forward contracts as a means of external techniques of risk management.
Part (b)
Stone Age Plc based in US expects to receive income from one of its subsidiaries based in UK in June 2009. The amount of receipts is £100, 000. Stone Age Plc does not want to face any currency risks. As such, Stone Age Plc intends to use options to manage the currency risks.
The current exchange rate is $1.650/£.
The details of the option contract are as follows:
Contract Amount: £ 25 000
Premium: £ 500 per contact
Exercise rate: $1. 600/£
In June 2009, the spot rate is $1.520/£.
Required:
(i) What is the cost of the option contract in $ terms?
(ii) With supporting workings, advise Stone Age Plc whether to exercise the option or not to exercise the option.
(iii). Outline the advantages of using options as a means of external risk management technique and illustrate how an option can be used to benefit from upside potential in case of a currency call option.