ABC International has a receivable valued at 500,000 local currency units from its foreign customer due in 90 days. The current spot rate of the local currency unit is $.60. ABC purchases a put option to sell the local currency unit in 90 days for $.61 for a premium of $.005. The exchange rate for the local currency increases to $.63 in 90 days. What will ABC do on the receivable's settlement date?
- ABC will exercise its option and sell the proceeds of its accounts receivable collection under the provisions of the option contract at a gain.
- ABC will not exercise the option and sell local currency units collected from its receivable at the spot rate.
- ABC will be indifferent as to whether it exercises the option or not.
- ABC will sell the option at the settlement date and combine its proceeds along with local currency units purchased at the spot rate to maximize its revenue.
Answer(s): B
Explanation:
Choice "b" is correct. ABC will not exercise its option and will, instead convert the local currency units collected from the receivables to its domestic currency by selling that currency at the spot rate at the time of collection. The exercise of the option represents a less profitable alternative than sale of the accounts receivable proceeds at the spot rate at the time the receivables are collected. The exercise of the option in comparison to allowing the option to expire is computed as follows:
The premium is a sunk cost and is irrelevant to the Explanation. Note that the premium is a factor in determining the net gain (loss) but not in deciding whether to exercise option.
Choices "a", "c", and "d" are incorrect, per computation above.