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Question (Relevant to the Series 7)
A British company has signed a contract to purchase products in the US for resale in Britain. However, the deal has been delayed. In order to hedge themselves against a possible rise in the strength of the US dollar, of the following options, what would be the most logical strategy?
A. Buy puts on the pound
B. Write calls on the dollar
C. Buy puts on the dollar
D. Buy calls on the pound
Answer: A. In this question, the British company is an importer into Britain. It is concerned that the dollar will rise and that therefore it might have to pay more in British pounds for the US products (which are denominated in dollars). Using the mnemonic EPIC (Exporters buy Puts, Importers buy Calls), the British company is an importer and would buy a call on the dollar to hedge its currency risk. A call on the dollar would permit the purchaser to buy dollars in the future at a fixed price, thus hedging the currency risk. However, buying calls on the dollar is not one of the listed answer options, so the inverse of a call on the dollar would be a put on the pound, which is the correct answer.
C. Buy puts on the dollar
Your questions are not easy, which is a good thing. I use the acronym ECIP, if the foreign entity needs to transact in US dollars.