Foreign Exchange Hedge by Bank of America - Finance Assignment Help

Assignment Task

Background
Bank of America’s FX team was approached by a Europe-based corporation whose functional currency is the euro (EUR) to investigate its FX exposures. Given the nature of the company’s business, the client faced FX transaction exposures linked to a potential further appreciation of the USD.
The client’s objective was to be hedged against a potential appreciation of the greenback over the next 12 months with the added flexibility of participating in a potential rebound in the EUR/USD spot exchange rate.
As reported in Bank of America’s FX Strategy note of November 4th 2008, the bank’s forecast for EUR/USD called for a potential move higher over the next three to six months above 1.4000 before retracing to trade on a 1.30 handle. The risk however remains to the downside given the potential aggressive monetary easing going into year end.

Recommended strategies
Given current market conditions, in particular in the elevated implied volatility noted in the option market, and the client’s desire to participate in a potential ‘limited’ appreciation of the EUR, Bank of America proposed the following two strategies:
• Strategy 1 - Trigger reset
Client is initially long a 1.2970 EUR Put / USD Call option for expiry 12 months. The strike of the option is set At-the-Money-Forward (ATMF).
In the event that spot ever trades at or above 1.5050, without 1.1900 having previously traded, the client’s right to sell EUR/USD becomes an obligation (forward contract) at the same exchange rate of 1.2970.
In the event that spot ever trades at or below 1.1900, without 1.5050 having previously traded, the client’s right to sell EUR/USD becomes an obligation (forward contract) at the rate of 1.2650.

Benefits
The client benefits from a potential Long EUR Put / USD Call option position for zero cost and can participate in a potential appreciation of the euro up to 1.5050. In the event that 1.5050 ever trades, the client will be short EUR/USD forward at a rate that matches the Outright Forward at inception of the trade. Only in the event that spot EUR/USD moves straight through the 1.1900 Reset Trigger will the client be required to sell EUR/USD at the reset strike of 1.2650. At this point, spot will be trading below 1.1900 and the client will benefit from a ‘deep in the money’ position despite the reset penalty of 320 USD pips.

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