Question 3c
Kenduri Co is a large multinational company based in the UK with a number of subsidiary companies around the world. Currently, foreign exchange exposure as a result of transactions between Kenduri Co and its subsidiary companies is managed by each company individually.
Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting from the UK, with the Sterling Pound (£) as the base currency. If multilateral netting is undertaken, spot mid-rates would be used.
The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan (currency JPY).
| Owed by | Owed to | Amount |
|---|---|---|
| Kenduri Co | Lakama Co | US$ 4.5 million |
| Kenduri Co | Jaia Co | CAD 1.1 million |
| Gochiso Co | Jaia Co | CAD 3.2 million |
| Gochiso Co | Lakama Co | US$ 1.4 million |
| Jaia Co | Lakama Co | US$ 1.5 million |
| Jaia Co | Kenduri Co | CAD 3.4 million |
| Lakama Co | Gochiso Co | JPY 320 million |
| Lakama Co | Kenduri Co | US$ 2.1 million |
Exchange rates available to Kenduri Co
| US$/£1 | CAD/£1 | JPY/£1 | |
|---|---|---|---|
| spot | 1.5938-1.5962 | 1.5690-1.5710 | 131.91-133.59 |
| 3 month forward | 1.5996-1.6037 | 1.5652-1.5678 | 129.15-131.05 |
Currency options available to Kenduri Co
Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1
| Exercise | Call options 3-month expiry | Call options 6-month expiry | Put options 3-month expiry | Put options 6-month expiry |
|---|---|---|---|---|
| 1.60 | 1.55 | 2.25 | 2.08 | 2.23 |
| 1.62 | 0.98 | 1.58 | 3.42 | 3.73 |
It can be assumed that option contracts expire at the end of the relevant month
Annual interest rates available to Kenduri Co and subsidiaries
| Borrowing rate | Investing Rate | |
|---|---|---|
| UK | 4.0% | 2.8% |
| United States | 4.8% | 3.1% |
| Canada | 3.4% | 2.1% |
| Japan | 2.2% | 0.5% |
Required:
When examining different currency options and their risk factors, it was noticed that a long call option had a high gamma value. Explain the possible characteristics of a long call option with a high gamma value. (3 marks)