Question

North Shore Equipment (NSE), a U.S. company, consistently purchases steel from a supplier in Japan with the invoice price denominated in Japanese yens. During the past year, NSE experienced substantial losses from foreign currency exchanges due to fluctuations in the exchange rate of the U.S. dollar to the Japanese yen. Therefore, Hector Hodgdon, NSE's CEO, has asked you to examine whether derivative financial instruments (e.g., foreign currency forward contracts and foreign currency options) to hedge the company's exposure to foreign exchange risk should be used going forward.

Required

Write a memo to CEO Hodgdon discussing any advantages and/or disadvantages of using forward contracts and options as a hedge against foreign exchange risk. Please be sure to recommend which type of hedging instrument you believe NSE should use. Make sure to justify your recommendation. Please make sure to properly cite any resources you use to answer this question.

Answer 1

Option 1 - Using of Forward Contracts :

Advantages:

• importing (exporting) businesses are protected against an excessive depreciation (strengthening) of their local currency by a guaranteed minimum (maximum) rate;
• possibility of reversing the transaction at any time given that it is a very liquid market;
• makes budgeting easier as the minimum (maximum) amounts to be received or paid are known;
• easy to manage, recorded off-balance sheet for the business.

Disadvantages:

• no possibility of benefiting from a favourable exchange rate fluctuation between the determination date and the settlement date (due date);
• difficult to synchronise between the foreign exchange transaction and the forward foreign exchange rate if the payment date is not known from the beginning.

Option 1 - Using of Options :

Advantages:

• Leverage. Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
  
• Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited upside with limited downside.
  
• Unique Strategies. Options allow you to create unique strategies to take advantage of different characteristics of the market - like volatility and time decay.
  
• Low capital requirements. Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much with $1,000 in the stock market.

Disadvantages:

• Lower liquidity. Many individual stock options don't have much volume at all. The fact that each optionable stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes. This lower liquidity won't matter much to a small trader that is trading just 10 contracts though.
  
• Higher spreads. Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade.
  
• Higher commissions. Options trades will cost you more in commission per dollar invested. These commissions may be even higher for spreads where you have to pay commissions for both sides of the spread.
  
• Complicated. Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don't.
  
• Time Decay. When buying options you lose the time value of the options as you hold them. There are no exceptions to this rule.
  
• Less information. Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
  
• Options not available for all stocks. Although options are available on a good number of stocks, this still limits the number of possibilities available to you.

  Recommendation:

Use Option contracts

Reason :

Forwards allow the importer to eliminate the risk of having to buy Japanese yens by exchanging more Dollars on account of the depreciating dollar. However, if the dollar appreciates, the importer will stand to lose. This is because he would be obligated to buy Japanese yens by exchanging Dollars at the predetermined rate and would be unable to exchange dollars for Japanese yens at the prevailing favorable exchange rate. This disadvantage can be overcome by buying a call option that would give the importer the right to buy the currency at a predetermined rate rather than obligate him to do so. American call options allow the purchase of currency at the predetermined contract price on or before the expiry of the contract. European options, on the other hand, allow the purchase of currency only on the expiry of the contract.