Question

1. USCom, a US computer manufacturer, will be delivering a large computer system to a German firm in six months. USCom expects to receive a payment of €1.5 million at that time. Currently the spot rate is US $1.45/€, and the six-month forward rate is US $1.47/€. Suppose that the firm also has the following information from the options market:

• Six-month call option premium is US $0.0195 per euro and the exercise price is $1.42,
• Six-month call option premium is US $0.0005 per euro and the exercise price is $1.48,
• Six-month put option premium is US $0.0012 per euro and the exercise price is $1.44,
• Six-month put option premium is US $0.0032 per euro and the exercise price is $1.46.

1. Describe how USCom can hedge the currency risk with forwards and options. What are the differences between forwards and options as hedging instruments?
2. If in six months the spot rate is US $1.43/€, what are the profits and losses on the hedging strategies? What if the spot rate is US $1.48/€? Based on your calculations, which strategy is most preferable when you make the hedging decision and why?
3. If euro futures are also available, how would you hedge the currency risk with futures? What are the differences between futures and forwards?

Answer 1

Solution:

a.

Hedging the currency risk using forwards:

USCom should enter into the given six-month Euro forward contract as short party so as to sell 1.5 million Euros after six months and receive fix amount of dollars according to the forward rate of US $1.47/€.

Hedging the currency risk using options:

USCom should buy the put options with exercise price of $1.44 to sell 1.5 million Euros at the fixed price of $1.44 if the Euros depreciats and in case Euros appreciate then the company will not exercise this option.

Differences between forwards and options as hedging instruments:
Forwards	Options
No upfronts fees need to be paid.	Upfront premium needs to be paid.
Parties to forward contract has obligation to meet future commitment according to fixed forward rate.	Option buyer has right but not the obligation to exercise the option.
Parties to forward contract needs to make the payment according to the forward rate irrespective of the movement in the undelying asset.	Option buyer will only exercise the option if it is profitable to him.

b.

Spot rate in six months is US $1.43/€:

1) Forwards hedging strategy:

Profit/Loss per euro = -(Spot rate - Forward rate) = -(1.43 - 1.45) = US $0.02

This stategy will lead to overall profit for the firm.

Overall Profit = 0.02 x 1,500,000 = US $30,000

2) Options hedging strategy:

Option used is: Six-month put option premium is US $0.0012 per euro and the exercise price is $1.44,

Total premium paid = 0.0012 x 1,500,000 = US $1,800

Payoff per euro for this put option = Exercise price - Spot price = 1.44 - 1.43 = US $0.01

Total payoff for put option = 0.01 x 1,500,000 = US $15,000

Overall Profit = Total Payoff - Total premium paid = 15000 - 1800 = US $13,200

Spot rate in six months is US $1.48/€:

1) Forwards hedging strategy:

Profit/Loss per euro = -(Spot rate - Forward rate) = -(1.48 - 1.45) = - US $0.03

This stategy will lead to overall loss for the firm.

Overall Loss = -0.03 x 1,500,000 = - US $45,000

2) Options hedging strategy:

Option used is: Six-month put option premium is US $0.0012 per euro and the exercise price is $1.44,

Total premium paid = 0.0012 x 1,500,000 = US $1,800

Payoff per euro for this put option = Exercise price - Spot price = 1.44 - 1.48 = - US $0.04

As payoff is negative so this put option will not be exercised.

Overall Loss = - Total premium paid = - US $1800

The forwards strategy is most preferable when making the hedging decision according to the above calculations. The reason is that hedging is used as the firm expects euro to depreciate and in this case the profit usinf forwards strategy is higher than the option strategy. Though the loss is higher in case of forwards strategy if euro appreciates as compared to options strategy but the main reason for entering the hedging strategy for the firm is to minimise losses when euro depreciates and not to maximise profits when euro appreciates.

c.

If euro futures are available then the currency risk can be hedged by taking short position in the six month Euro futures contracts to sell 1.5 million euros at a fixed future rate. The firm will also need to make initial margin payment to enter into these future contracts.

Differences between futures and forwards:
Futures	Forwards
It is an exchange traded contract.	It is an over the counter contract.
These are standardised contracts.	These are customised contracts
Initial margin needs to be paid.	No need to make any initial investment.
There is a concept of mark to market for daily settlement of profit/loss.	No daily settlement of profit/loss.
Higher basis risk is involved because of their standardised nature.	Lower basis risk is involved because of their customised nature.
No credit risk is involved as exchage acts as a counter-party.	Credit risk is involved as it is a direct contract between two parties.

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