Using Options to Hedge a Conditional Exposure ICTV is a U.S. company that develops software for cable television networks. Executives at ICTV have just negotiated a £20 million deal with British cable...

Using Options to Hedge a Conditional Exposure

ICTV is a U.S. company that develops software for cable television networks. Executives at ICTV have just negotiated a £20 million deal with British cable operator Telewest. ICTV will receive the payment in six months’ time, after ICTV demonstrates a prototype proving the viability of its technology. If Telewest is not satisfied with the technology, it can cancel the contract at that time and pay nothing. ICTV executives have two major concerns: (1) their engineers may not be able to meet Telewest’s technology requirements and (2) even if the deal succeeds, the British pound may fall, reducing the dollar value of the £20 million payment.

Suppose the current exchange rate is $1.752/£, the six-month forward exchange rate is $1.75/£, and a six-month put option on the British pound with a strike price of $1.75/£ is trading for $0.05/£. Compare ICTV’s outcomes if it does not hedge, hedges using a forward contract, or hedges using the put option.