In: Finance
Hot Kustoms Company estimates that with 30% probability it will have to pay a supplier 10000 Hong Kong dollars in three months. How can Hot Kustoms best hedge this exposure? Explain. Would your answer change if Hot Kustoms had to pay the supplier with 100% certainty? Why or why not?
1.
As the payment is not certain, buy call option on Hong Kong
dollars. This is because the hedge should provide gains when Hong
Kong dollar appreciates, as that is the key risk. We buy calls
because we will have the right but not the obligation. So we will
only exercise when the payment has to be compulsorily made and also
it is advantageous for us to do so.
2.
As the payment is certain, buy currency forwards on Hong Kong
dollars. This is because the hedge should provide gains when Hong
Kong dollar appreciates, as that is the key risk. We buy forwards
because the payment is certain and in this case if we use calls we
would be unnecessarily paying call premiums.