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- Region: UK/US/Europe
- Australia
- New Zealand
- UK/US/Europe
Mr Cook is due to receive €1m in six months' time from the sale of his property in Europe.
When he investigated using a protection option, the exchange rate was 1.121 and the six month forward contract rate was 1.135. Mr Cook felt that the rate might fall further but didn't want it to go back over 1.16 as this would have reduced the number of pounds he would receive for his euros. A protection option at 1.16 would have cost 3.5% of the notional amount (i.e. €35,000) but Mr Cook felt that this was more than he wanted to pay.
To reduce the premium, Mr Cook was happy to cap his upside potential at a best case rate of 1.100 and keep his worst case rate of 1.160. This reduced the premium paid to zero.
This meant that regardless of what happened to the exchange rate over the next six months, if the rate was higher than 1.160 on the pre-agreed date in six months' time, he could convert his euros into pounds at 1.160.
Possible scenarios:
1) If the exchange rate rises and after six months is trading at 1.25
Mr Cook would sell €1m at 1.16, his worst case rate and receive £862,068.97 in return
2) If the exchange rate falls and after six months is trading at 1.08
Mr Cook would sell his €1m at 1.10, his best case rate and receive £909,090.91 in return
3) If the exchange rate falls between 1.10 (best case rate) and 1.160 (worse case rate) at expiry, for example 1.11
Mr Cook has the right to sell €1m at 1.11 and receive £900,900.90 in return
The downside of this strategy is that Mr Cook would have been better off being un-hedged if the rate at expiry is below 1.10.
The risk reversal option is very flexible. The band of rates can be altered to meet your requirements, resulting in either a zero premium or paid premium structure.
World First Markets Limited is authorised and regulated by the Financial Services Authority. Our Firm Reference Number is 477561
