Question

Blades, Inc., needs to order supplies 2 months ahead of the delivery date. It is considering an order from a Japanese supplier that requires a payment of 12.5 million yen pay- able as of the delivery date. Blades has two choices: Purchase two call options contracts (since each option contract represents 6,250,000 yen). Purchase one futures contract (which represents 12.5 million yen). The futures price on yen has historically exhibited a slight discount from the existing spot rate. However, the firm would like to use currency options to hedge payables in Japanese yen for transactions 2 months in advance. Blades would prefer hedging its yen payable position because it is uncomfortable leaving the position open given the historical volatility of the yen. Nevertheless, the firm would be willing to remain unhedged if the yen becomes more stable someday. Ben Holt, Blades’ chief financial officer (CFO), prefers the flexibility that options offer over forward contracts or futures contracts because he can let the options expire if the yen depreciates. He would like to use an exercise price that is about 5 percent above the existing spot rate to ensure that Blades will have to pay no more than 5 percent above the existing spot rate for a transaction 2 months beyond its order date, as long as the option premium is no more than 1.6 percent of the price it would have to pay per unit when exercising the option. In general, options on the yen have required a premium of about 1.5 percent of the total transaction amount that would be paid if the option is exercised. For example, recently the yen spot rate was $.0072, and the firm purchased a call option with an exercise price of $.00756, which is 5 percent above the existing spot rate. The premium for this option was $.0001134, which is 1.5 percent of the price to be paid per yen if the option is exercised. A recent event caused more uncertainty about the yen’s future value, although it did not affect the spot rate or the forward or futures rate of the yen. Specifically, the yen’s spot rate was still $.0072, but the option premium for a call option with an exercise price of $.00756 was now $.0001512. An alternative call option is available with an expiration date of 2 months from now; it has a premium of $.0001134 (which is the size of the premium that would have existed for the option desired before the event), but it is for a call option with an exercise price of $.00792. As an analyst for Blades, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of question 6.

6) Now assume that you have determined that the historical standard deviation of the yen is about $.0005. Based on your assessment, you believe it is highly unlikely that the future spot rate will be more than two standard deviations above the expected spot rate by the delivery date. Also assume that the futures price remains at its current level of $.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm?

Answer 1

if the standard deviation increases by 2% then the forecasted spot rate will be $0.007912 (calculated by $.006912+ (2*.0005000))

Cost of remain unhedged will be $98900 (computed by $.007912*12500000)

In case of purchasing future contract if 2% standard deviation increases then costs will be $86400 because there is no impact of increasing standard deviation on the future price.

In case of purchasing 2 options, for one option cost will be $48195 which is computed by (($.0075600+$.0001512)*6250000)

For 2nd option costs will be incurred $50209 which is computed by (($.0079200+.0001134)*6250000)

For option 1 exercise price is $0.00756

Total premium $1890

Amounts have to be paid for Yen + $94500

Total paid $96390

For option 2 exercise price is $.00792

Total premium $1417.50

Amounts have to be paid for Yen + $98900

Total paid $100317.50

In 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be able to generate profit using this option. But in case of 2nd option, spot rate is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc. should not exercise call options rather they should go for future contract.