Chapter 5. Currency Derivatives. Lecture Outline. Forward Market How MNCs Can Use Forward Contracts Non-Deliverable Forward Contracts

Transcription

1 Chapter 5 Currency Derivatives Lecture Outline Forward Market How MNCs Can Use Forward Contracts Non-Deliverable Forward Contracts Currency Futures Market Contract Specifications Trading Futures Comparison of Currency Futures and Forward Contracts Pricing Currency Futures Credit Risk of Currency Futures Contracts Speculation with Currency Futures How Firms Use Currency Futures Closing Out a Futures Position Transaction Costs of Currency Futures Currency Call Options Factors Affecting Call Option Premiums How Firms Use Currency Call Options Speculating with Currency Call Options Currency Put Options Factors Affecting Currency Put Option Premiums Hedging with Currency Put Options Speculating with Currency Put Options Contingency Graphs for Currency Options Conditional Currency Options European Currency Options

2 Chapter Theme This chapter provides an overview of currency derivatives, which are sometimes referred to as speculative. Yet, firms are increasing their use of these instruments for hedging. The chapter does give speculation some attention, since this is a good way to illustrate the use of a particular instrument based on certain expectations. However, the key is that students have an understanding why firms would consider using these instruments and under what conditions they would use them. Topics to Stimulate Class Discussion 1. Why would a firm ever consider futures contracts instead of forward contracts? 2. What advantage do currency options offer that are not available with futures or forward contracts? 3. What are some disadvantages of currency option contracts? 4. Why do currency futures prices change over time? 5. Why do currency options prices change over time? 6. Set up several scenarios, and for each scenario, ask students to determine whether it would be better for the firm to purchase (or sell) forward contracts, futures contracts, call option contracts, or put options contracts. Critical debate: Hedging Proposition: MNC s should not protect against currency changes. Investors take into account currency risks and the diversification benefits from investing in companies that conduct international business. But if these companies are going to protect themselves against one of the main sources of diversification, namely currency changes, they are in effect denying investors the opportunity to benefit from such diversification in order to protect their own positions as directors. Opposing view: Companies specialize in certain activities that generally do not include currency speculation. Derivatives enable such companies to specialize in more clearly defined risks. The protection is in any case only short term, no protection is being offered for long term changes in the value of a currency. Derivatives simply avoid distortion to profits caused by unusual changes to currency values. Such currency shocks could lead to abnormal share price movements that might adversely affect individual shareholders who have to sell for personal reasons. With whom do you agree? How should the investment community view business risk? Should shareholders be more aware of the currency risk policy of the company? Are directors protecting their own positions at the expense of the shareholder? Offer your own opinion on this issue.

3 The mian ppoint is trhat the company should heve a clearly defined foreign exchange rate policy. Annual reports states clearly the general poicy of companies. Often that they do not hedge translation risk as in this example from Renault 2004 Renault does not generally hedge its future operating cash flows in foreign currencies. The operating margin is therefore subject in the future to changes caused by exchange rate fluctuations. In this way, Renault averages out any impacts over a long period, while not assuming the risks inherent in forward currency hedging. Often an extimate of the impact of a change in the exchange rate on operation profits will also be given. For example from the same report: How shareholder probably has little say over such a detailed policy, but investing in Renault does make it clear as to how earnings if not share price reacts to the exchange rate. Later in the text it is shown that share prices react predominantly in relation to the home country share index, so the idea that one can buy exposure to foreign currencies in this way is a bit of a myth. Answers to End of Chapter Questions 1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts. 2. Using Currency Futures. a. How can currency futures be used by corporations? U.S. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. U.S. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. b. How can currency futures be used by speculators? Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 3. Currency Options. Differentiate between a currency call option and a currency put option.

4 A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. 4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is 0.05 and spot rate is State whether your answer is a discount or premium. (F - S) / S = ( )/0.051 x 360/90 = or -7.8% a discount therefore 5. Effects of a Forward Contract. How can a forward contract backfire? If the spot rate of the foreign currency at the time of the transaction is worth less than the forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward contract has backfired. 6. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging? A call option can hedge a firm s future payables denominated in euros. It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm s future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received. 7. Speculating With Currency Options. When should a speculator purchase a call option on Australian dollars? When should a speculator purchase a put option on Australian dollars? Speculators should purchase a call option on Australian dollars if they expect the Australian dollar value to appreciate substantially over the period specified by the option contract. Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value to depreciate substantially over the period specified by the option contract. 8. Currency Call Option Premiums. List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option on dollars (assuming the expiration date and the total dollar value represented by each option are the same for both options)? These factors are listed below: The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal.

5 The longer the period prior to the expiration date, the greater is the call option value, other things equal. The greater the variability of the currency, the greater is the call option value, other things equal. The at-the-money call option in euros should have a lower premium because the euro should have less volatility than the dollar. 9. Currency Put Option Premiums. List the factors that affect currency put options and briefly explain the relationship that exists for each. These factors are listed below: The lower the existing spot rate relative to the strike price, the greater is the put option value, other things equal. The longer the period prior to the expiration date, the greater is the put option value, other things equal. The greater the variability of the currency, the greater is the put option value, other things equal. 10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for 0.02 euros per unit. The strike price was 1.45euros, and the spot rate at the time the option was exercised was 1.46 euros. Assume there are 31,250 units in a British pound option. What was Randy s net profit on this option? Profit per unit on exercising the option Premium paid per unit Net profit per unit Net profit per option = 31,250 units ( 0.01 euros) = 0.01 euros = 0.02 euros = 0.01 euros = euros 11. Speculating with Currency Put Options. Alice Duever purchased a put option on dollars for 0.04 per unit. The strike price was 0.55, and the spot rate at the time the dollar option was exercised was Assume there are 50,000 units in a US dollar option. What was Alice s net profit on the option? Profit per unit on exercising the option = 0.00 option not exercised Premium paid per unit = 0.04 Net profit per unit = Net profit for one option = 31,250 units $.17 = - 1, Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for 0.01 per unit. The strike price was 0.42, and the spot rate at the time the option was exercised was Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike s net profit on the call option?

6 Firstly, the call option will be exercised Premium received per unit = 0.01 Amount per unit received from selling C$ at strike = 0.42 Amount per unit paid when purchasing C$ = 0.46 Net profit per unit = Net Profit = 50,000 units ( 0.03) = 1, Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for 0.02 per unit. The strike price was 0.42, and the spot rate at the time the option was exercised was Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Brian s net profit on the put option? Firstly, the put option will be exercised Premium received per unit = 0.02 Amount per unit received from selling C$ at spot = 0.40 Amount per unit paid for C$ = 0.42 Net profit per unit = Forward versus Currency Option Contracts. What are the advantages and disadvantages to an MNC that uses currency options on euros rather than a forward contract on euros to hedge its exposure in euros? Explain why an MNC use forward contracts to hedge committed transactions and use currency options to hedge contracts that are anticipated but not committed. Why might forward contracts be advantageous for committed transactions, and currency options be advantageous for anticipated transactions? A currency option on euros allows more flexibility since it does not commit one to purchase or sell euros (as is the case with a euro futures or forward contract). Yet, it does allow the option holder to purchase or sell euros at a locked-in price. The disadvantage of a euro option is that the option itself is not free. One must pay a premium for the call option, which is above and beyond the exercise price specified in the contract at which the euro could be purchased. An MNC may use forward contracts to hedge committed transactions because it would be cheaper to use a forward contract (a premium would be paid on an option contract that has an exercise price equal to the forward rate). The MNC may use currency options contracts to hedge anticipated transactions because it has more flexibility to let the contract go unexercised if the transaction does not occur. 15. Speculating with Currency Futures. Assume that the euro s spot rate has moved in cycles over time. How might you try to use futures contracts on euros to capitalize on this tendency? How could you determine whether such a strategy would have been profitable in previous periods?

7 Use recent movements in the euro to forecast future movements. If the euro has been strengthening, purchase futures on euros. If the euro has been weakening, sell futures on euros. A strategy s profitability can be determined by comparing the amount paid for each contract to the amount for which each contract was sold. We need to note that currencies do not move in patterns, it would be noticed by other traders! 16. Hedging with Currency Derivatives. Assume that the transactions listed in the first column of the following table are anticipated by UK firms that have no other foreign transactions. Place an X in the table wherever you see possible ways to hedge each of the transactions. a. George ltdplans to purchase Japanese goods denominated in yen. b. Harvard ltd sold goods to Japan, denominated in yen. c. Yale plc has a subsidiary in Australia that will be remitting funds to the U.S. parent. d. Brown ltd needs to pay off existing loans that are denominated in Canadian dollars. e. Princeton ltd may purchase a company in Japan in the near future (but the deal may not go through). Forward Contract Futures Contract Options Contract Forward Forward Buy Sell Purchase Purchase Purchase Sale Futures Futures Calls Puts a. X X X b. X X X c. X X X d. X X X e. X 17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was 0.63 and the price on a December futures contract was Assume that the pound depreciated during November so that by November 30 it was worth a. What do you think happened to the futures price over the month of November? Why? The December futures price would have decreased, because it reflects expectations of the future spot rate as of the settlement date. If the existing spot rate is 0.60, the spot rate expected on the December futures settlement date is likely to be near 0.60 as well. As you get closer to the maturity date so the difference between buying at spot and buying using a futures decreases, so as the law of one price dictates, the price should be nearly the same for nearly the same service. b. If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1? Explain.

8 You would have sold futures at the existing futures price of Then as the spot rate of the pound declined, the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in the spot market at 0.60, and fulfill the futures obligation by delivering pounds at the price of 0.64 per dollar. 18. Speculating with Currency Futures. Assume that a March futures contract on Mexican pesos was available in January for $.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $.092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative activity affect the difference between the forward contract price and the futures price? Speculators could purchase peso futures for $.09 per unit, and simultaneously sell pesos forward at $.092 per unit. When the pesos are received (as a result of the futures position) on the settlement date, the speculators would sell the pesos to fulfill their forward contract obligation. This strategy results in a $.002 per unit profit. As many speculators capitalize on the strategy described above, they would place upward pressure on futures prices and downward pressure on forward prices. Thus, the difference between the forward contract price and futures price would be reduced or eliminated. 19. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar call options for speculative purposes. If these options are exercised, LSU will immediately sell the Canadian dollars in the spot market. Each option was purchased for a premium of $.03 per unit, with an exercise price of $.75. LSU plans to wait until the expiration date before deciding whether to exercise the options. Of course, LSU will exercise the options at that time only if it is feasible to do so. In the following table, fill in the net profit (or loss) per unit to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration date. Possible Spot Rate Net Profit (Loss) per of Canadian Dollar Unit to LSU Corporation on Expiration Date if Spot Rate Occurs $.76 $ Speculating with Currency Put Options. Auburn ltd has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of 0.02 per unit, with an exercise price of 0.48 per unit. Auburn ltd will purchase the Canadian dollars just before it exercises the options (if it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit (or loss) per unit to Auburn ltd based on the listed possible spot rates of the Canadian dollar on the expiration date.

9 Possible spot rate on Canadian dollar Net profit (loss) per unit to Auburn on expiration ltd date Speculating with Currency Call Options. Bama plc has sold dollar call options for speculative purposes. The option premium was 0.04 per unit, and the exercise price was Bama will purchase the dollars on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit (or loss) to Bama plc if the listed spot rate exists at the time the purchaser of the call options considers exercising them. Possible spot rate at the time the purchaser of the Call option (American style) considers exercising them Net profit (loss) per unit to Bama Corp. 22. Speculating with Currency Put Options. Bulldog ltd has sold Australian dollar put options at a premium of 0.01 per unit, and an exercise price of 0.42 per unit. It has forecasted the Australian dollar s lowest level over the period of concern as shown in the following table. Determine the net profit (or loss) per unit to Bulldog ltd if each level occurs and the put options are exercised at that time. Possible value of Australian dollar Net profit (loss) per unit to Bulldog ltd if value occurs

10 Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging? The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved. Advanced Questions 24. Risk of Currency Futures. Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that dollars value would continue to decline. However, the Fed intervened in the foreign exchange market by immediately buying dollars with foreign currency, causing an abrupt halt in the decline in the value of the dollar. Participants that had sold dollar futures contracts for a range of other currencies incurred large losses. a. Explain why the central bank s intervention caused such panic among currency futures traders with buy positions. Futures prices on pounds rose in tandem with the value of the pound. However, when central banks intervened to support the dollar, the value of the pound declined, and so did values of futures contracts on pounds. So traders with long (buy) positions in these contracts experienced losses because the contract values declined. b. Some traders with buy positions may have responded immediately to the central bank s intervention by selling futures contracts. Why would some speculators with buy positions leave their positions unchanged or even increase their positions by purchasing more futures contracts in response to the central bank s intervention? Central bank intervention sometimes has only a temporary effect on exchange rates. Thus, the European currencies could strengthen after a temporary effect caused by central bank intervention. Traders have to predict whether natural market forces will ultimately overwhelm any pressure induced as a result of central bank intervention.

11 25. Currency Straddles. Reska ltd has constructed a long euro straddle. A call option on euros with an exercise price of 0.61 has a premium of per unit. A euro put option has a premium of per unit. Some possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.) a. Complete the worksheet and determine the net profit per unit to Value of Euro at option Expiration Call Put Net Reska, ltd for each possible future spot rate. b. Determine the break-even point(s) of the long straddle. What are the break-even points of a short straddle using these options? the cost is the combined premiums so = 0.023, so the difference above and below the strike price of 0.61 must cosver this cost i.e = and = so the breakeven points are and The short straddle for the same exercise price is the other side, the seller of the call and seller of the put. The breakeven points are the same. 26. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are 0.01 per unit and per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long euro straddle. b. Construct a contingency graph for a short euro straddle. a. profit = = = Future spot rate Loss

12 b profit = Future spot rate = = Loss

13 27. Currency Option Contingency Graphs. (See Appendix B in this chapter.) The current spot rate of the Singapore dollar (S$) is The following option information is available: Call option premium on Singapore dollar (S$) = Put option premium on Singapore dollar (S$) = Call and put option strike price = 0.36 One option contract represents S$70,000. Construct a contingency graph for a short straddle using these options profit = Future spot rate = = Loss 28. Speculating with Currency Straddles. Maggie Hawthorne is a currency speculator. She has noticed that recently the dollar has depreciated substantially against the euro. The current exchange rate of the dollar is 0.78 euro. After reading a variety of articles on the subject, she believes that the dollar will continue to fluctuate substantially in the months to come. Although most forecasters believe that the dollar will depreciate against the euro in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on dollars is available with an exercise price of 0.80 euro and a premium of 0.04 euro. A dollar put option with an exercise price of 0.80 euro and a premium of 0.03 euro is also available. (See Appendix B in this chapter.) a. Describe how Maggie could use straddles to speculate on the dollar s value. b. At option expiration, the value of the dollar is 0.90 euro. What is Maggie s total profit or loss from a long straddle position? c. What is Maggie s total profit or loss from a long straddle position if the value of the dollar is 0.60 euro at option expiration? d. What is Maggie s total profit or loss from a long straddle position if the value of the dollar at option expiration is still 0.78 euro? e. Given your answers to the questions above, when is it advantageous for a speculator to engage in a long straddle? When is it advantageous to engage in a short straddle? ANSWER

14 a. Since Maggie believes the dollar will either appreciate or depreciate substantially, she may consider purchasing a straddle on dollar. b. Per Unit Selling Price of $ 0.90 euro Purchase price of $ euro Premium paid for call option euro Premium paid for put option -0.03euro = Net profit 0.03 euro c. Per Unit Selling Price of 0.80 euro Purchase price of euro Premium paid for call option euro Premium paid for put option -0.03euro = Net profit 0.17 euro d. Per Unit Selling Price of 0.80 Purchase price of 0.78 Premium paid for call option euro Premium paid for put option -0.03euro = Net profit euro e. It is advantageous for a speculator to engage in a long straddle if the underlying currency is expected to fluctuate drastically, in either direction, prior to option expiration. This is because the advantage of benefiting from either an appreciation or depreciation is offset by the cost of two option premiums. It is advantageous for a speculator to engage in a short straddle if the underlying currency is not expected to deviate far from the strike price prior to option expiration. In that case, the speculator would collect both premiums, and the loss associated with either the call or the put option is minimal.

15 29. Currency Strangles. (See Appendix B in this chapter.) Assume the following options are currently available for dollars: Call option premium on dollars = 0.04 per unit Put option premium on dollars = 0.03 per unit Call option strike price = 0.64 Put option strike price = 0.62 One option contract represents $50,000. a. Construct a worksheet for a long strangle using these options. b. Determine the break-even point(s) for a strangle. c. If the spot price of the dollar at option expiration is 0.63, what is the total profit or loss to the strangle buyer? d. If the spot price of the dollar at option expiration is 0.60, what is the total profit or loss to the strangle writer? a. Many different worksheets are possible, but one worksheet is shown below. Value of Dollar at Option Expiration Call Put Gain Net b. The break-even points for a strangle are located below the lower exercise price and above the higher exercise price. The lower break-even point is located at 0.62 ( ) = The higher break-even point is located at ( ) = 0.71 c. Since 0.63 is between the two exercise prices, neither option will be exercised, and the strangle buyer will incur the maximum loss of d. If the spot price is 0.60, the put option will be exercised, but the call option will expire. On the put option, the strangle writer will lose = The writer will also collect the premiums from both options of Therefore, the strangle writer will net 0.05 = Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are per unit and per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long pound straddle. b. Construct a contingency graph for a short pound straddle.

16 a. The total premiums are = 0.06 plotted points should create a U shape that cuts through the horizontal (break-even) axis at = 0.56 and = The bottom of the U shape occurs from 0.56 to 0.70 and reflects a net cost of 0.06 per unit. Profit per unit Loss per unit 0.06 Future spot rate b. Profit per unit Loss per unit Future spot rate

17 31. Currency Strangles. The following information is currently available for Canadian dollar (C$) options (see Appendix B in this chapter): Put option exercise price = 0.45 Put option premium = per unit Call option exercise price = 0.46 Call option premium = 0.01 per unit One option contract represents C$50,000. a. What is the maximum possible gain the purchaser of a strangle can achieve using these options? b. What is the maximum possible loss the writer of a strangle can incur? c. Locate the break-even point(s) of the strangle. a. The maximum gain for the purchaser of a long strangle is unlimited for currency appreciation and depreciation. b. The maximum loss for the purchaser of a long strangle is unlimited for currency appreciation and depreciation. c. The lower break-even point is obtained by subtracting both premiums from the put option exercise price ie 0.45 ( ) = The upper break-even points is obtained by adding both premiums to the call option exercise price, at ( ) = Currency Strangles. For the following options available on Australian dollars (A$), construct a worksheet and contingency graph for a long strangle. Locate the break-even points for this strangle. (See Appendix B in this chapter.) Put option strike price = 0.42 Call option strike price = 0.40 Put option premium = 0.01 per unit Call option premium = 0.02 per unit. The combined premiums are: = 0.03 The lower Breakeven point is = 0.39 The higher one is = 0.43 Ie it is still from the put strike price even though it is higher than the call strike.

18 33. Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the Japanese yen will fluctuate widely against the euro in the coming month. Currently, one-month call options on Japanese yen ( ) are available with a strike price of euro and a premium of euro per unit. One-month put options on Japanese yen are available with a strike price of euro and a premium of euro per unit. One option contract on Japanese yen contains 6.25 million yen. (See Appendix B in this chapter.) a. Describe how Barry Egan could utilize these options to speculate on the movement of the Japanese yen. b. Assume Barry decides to construct a long strangle in yen. What are the break-even points of this strangle? c. What is Barry s total profit or loss if the value of the yen in one month is euro? d. What is Barry s total profit or loss if the value of the yen in one month is ? euro a. Since Barry seems uncertain as to the direction of the yen fluctuation, he could construct a long straddle using the call and put option. The long strangle would become profitable if the yen either depreciates or appreciates substantially. b. Lower BE point = ( ) = Upper BE point = ( ) = c. Per Unit Per Contract (euro) Selling Price of ,500 ( million units) Purchase price of ,750 ( million units) Premium paid for call option ,375 ( million units) Premium paid for put option ,125 ( million units) = Net profit ,250 ( million units) d. Per Unit Per Contract (euro) Selling Price of ,250 ( million units) Purchase price of ,125 ( million units) Premium paid for call option ,375 ( million units) Premium paid for put option ,125 ( million units) = Net profit ,375 ( million units) 34. Currency Bullspreads and Bearspreads. A call option on dollars exists with a strike price of 0.64 and a premium of 0.04 per unit. Another call option on dollars has a strike price of 0.66 and a premium of 0.03 per unit. (See Appendix B in this chapter.) a. Complete the worksheet for a bull spread below. Value of Dollar at Option expiration

19 Net b. What is the break-even point for this bull spread? c. What is the maximum profit of this bull spread? What is the maximum loss? d. If the dollar spot rate is 0.65 at option expiration, what is the total profit or loss for the bull spread? e. If the dollar spot rate is 0.63 at option expiration, what is the total profit or loss for a bear spread? a. Value of Dollar at Option expiration Call@ Call@ Net b. The breakeven point of a bullspread occurs at the lower exercise price plus the difference in premiums, at = c. The maximum gain for the bullspread is limited to the difference between the strike prices less the difference in the premiums, or 0.01 = The maximum loss for the bullspreader limited to the difference in the option premiums, or = d. Per Unit Selling Price of 0.65 Purchase price of 0.64 Premium paid for call option Premium received for call option 0.03 = Net profit 0.00 e. At a spot price of 0.63, neither call option will be exercised, so the bearspreader nets the difference in options premiums. Per Unit + Premium paid for call option Premium received for call option 0.03 = Net profit Bullspreads and Bearspreads. Two dollar put options are available with exercise prices of 0.70 and The premiums associated with these options are 0.02 and 0.03 per unit, respectively. (See Appendix B in this chapter.) Value of Dollar at Option expiration

20 Net a. Describe how a bull spread can be constructed using these put options. What is the difference between using put options versus call options to construct a bull spread? b. Complete the following worksheet. c. At option expiration, the spot rate of the pound is What is the bull spreader s total gain or loss? d. At option expiration, the spot rate of the pound is What is the bear spreader s total gain or loss? a. Using put options to construct a bullspread involves exactly the same actions as constructing a bullspread using call options. The bullspreader would buy the 0.70 put option and write the 0.72 put option. The difference between using call and put options to construct a bullspread is that using put options results in gains due to premium differential and losses due to exercising, with calls the cause is the other way around. b Put@0.70 premium Put@0.72 premium Net c. d. Per Unit Selling price of $ 0.70 Purchase price of $ Premium paid for put option.02 + Premium received for put option payout on put = Net profit 0.01 Per Unit Selling price of $ 0.70 Purchase price of $ Premium received for put option +.03 Premium paid for put option.02 -payout on put = Net profit Profits from Using Currency Options and Futures. On July 2, the two-month futures rate of the Mexican peso contained a 2 percent discount (unannualized). There was a call option on pesos with an exercise price that was equal to the spot rate. There was also a put option on pesos with an exercise price equal to the spot rate. The premium on each of these options was

21 3 percent of the spot rate at that time. On September 2, the option expired. Go to the oanda.com website (or any site that has foreign exchange rate quotations) and determine the direct quote of the Mexican peso. You exercised the option on this date if it was feasible to do so. a. What was your net profit per unit if you had purchased the call option? b. What was your net profit per unit if you had purchased the put option? c. What was your net profit per unit if you had purchased a futures contract on July 2 that had a settlement date of September 2? d. What was your net profit per unit if you sold a futures contract on July 2 that had a settlement date of September 2? The answer depends on exchange rates on the specified dates. This question forces students to look up exchange rate information before determining the net profit. 37. A U.K. MNC takes out a cylinder option to buy dollars between the rates of 0.75 and 0.85 per U.S. dollar. (See Appendix B in this chapter.) a. Describe the implied options in the contract. b. Explain potential payoffs from the options and their total effect on the MNC s cost of purchasing the dollar. a. The MNC wants to buy a call option at 0.85 in order to protect against a very expensive dollar. To help finance this purchase it can write a put option. The revenue from the put option offsets the cost of the call option. Often the strike prices are arranged such that there is a full option offset and no net payment to be made from writing one option and buying the other option. b. Between the two strike prices both the options are out of the money, thus the MNC will normally have no payment to make under this combined option (see a). Above the higher strike price the MNC will receive the difference with the higher strike price from its call option. Such payment will normally help offset a payment in foreign currency thus limiting its cost. Below the lower strike price the MNC will have to make a payment under the written put option. For an MNC this will be in addition to a payment in a foreign currency. Thus the costs are limited to being no less than at the lower rate. The combined effect is for the cost of the foreign currency to be between the two stike prices.

22 Blades plc Case Study Blades plc needs to order supplies two months ahead of the delivery date. It is considering an order from a Japanese supplier that requires a payment of 12.5 million yen payable 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 two 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 finance director, 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 two 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 and the firm purchased a call option with an exercise price of , which is 5 percent above the existing spot rate. The premium for this option was , 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 , but the option premium for a call option with an exercise price of was now An alternative call option is available with an expiration date of two months from now; it has a premium of (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 The table below summarizes the option and futures information available to Blades. As an analyst for Blades, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of questions 4 and 6.

23 Before Event After Event Spot rate Option Information: Exercise price ( ) Exercise price (% above spot) 5% 5% 10% Option premium per yen ( ) Option premium (% of 1.5% 2.0% 1.5% exercise price) Futures Contract Information: Futures price If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of or the call option with the exercise price of ? Describe the tradeoff. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff. 3. Assume there are speculators who attempt to capitalize on their expectation of the yen s movement over the two months between the order and delivery dates by either buying or selling yen futures now and buying or selling yen at the future spot rate. Given this information, what is the expectation on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.) 4. Assume that the firm shares the market consensus of the future yen spot rate. Given this expectation and given that the firm makes a decision (i.e., option, futures contract, remain unhedged) purely on a cost basis, what would be its optimal choice? 5. Will the choice you made as to the optimal hedging strategy in question 4 definitely turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not? 6. Now assume that you have determined that the historical standard deviation of the yen is about 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 Based on this expectation of the future spot rate, what is the optimal hedge for the firm? Solution to Continuing Case Problem: Blades 1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of or the call option with the exercise price of ? Describe the tradeoff. The table shows how the option choices have changed for Blades. If it wants to ensure paying no more than 5 percent above the spot rate, the option with the exercise price of should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of , but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firm s desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer,

24 or a higher exercise price that limits the effectiveness of the hedge. If it decides to use an option, the tradeoff is paying a premium of x 12.5m = 1,250 to limit the payables amount to 63,000 or paying a premium of x 12.5m = 945 to limit the payables amount to 66,500. The preferred option depends on the firm s assessment about the yen, but many analysts would select the higher premium (an extra 305) to pay for the lower limit on payables. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff. Blades could also remain unhedged, but given its previous desire to hedge because of the volatile movements even before the event, it would have an even stronger desire to hedge once the event caused more uncertainty about the yen s future value. Since futures prices were not affected by the uncertainty-increasing event, Blades should seriously consider futures contracts as an alternative to options. Thus, the firm could purchase a futures contract and lock in its future payment at the same futures price as before the event. 3. Assume there are speculators who attempt to capitalize on their expectation of the yen s movement over the two months between the order and delivery dates by either buying or selling yen futures now and buying or selling yen at the future spot rate. Given this information, what is the expectation on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.) If there are speculators who attempt to capitalize on their expectation of the yen s future movement, then the expectation of the future spot rate would be equal to the futures rate. For example, suppose speculators expect the yen to appreciate. They would buy yen futures now. If the yen appreciates, they will buy the yen at the futures rate in two months and sell them at the spot rate prevailing at that time. Thus, if the market expectation is that the yen will appreciate, all speculators will engage in similar actions, which would place upward pressure on the futures rate and downward pressure on the expected future spot rate. This process continues until the futures rate is equal to the expected future spot rate. Therefore, the expected spot rate at the delivery date is equal to the futures rate. 4. Assume that the firm shares the market consensus of the future yen spot rate. Given this expectation and given that the firm makes a decision (i.e., option, futures contract, remain unhedged) purely on a cost basis, what would be its optimal choice? (See spreadsheet attached.) The optimal choice, given the expected future spot rate in question 3 and given that the decision is made solely on a cost basis, is to purchase one futures contract, which would result in an actual cost on the delivery date of 12,500,000 x = 57,600. Although remaining unhedged also has an expected cost of 60,000, actual costs incurred on the delivery date to purchase yen may deviate substantially from this value, depending on the movements of the yen between the order date and the delivery date. Consequently, the firm will probably prefer using a futures contract over remaining unhedged. 5. Will the choice you made as to the optimal hedging strategy in question 4 definitely turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not? No, as mentioned in the case, the yen is very volatile and, therefore, the actual costs incurred may turn out to be lower had the firm employed either an option to hedge the

25 yen payable or remained unhedged. By employing a futures contract to hedge, which locks the firm into the price it will pay to buy the yen at the delivery date, the firm forgoes any cost advantage that may result from a substantial depreciation of the yen by the delivery date. In that case, remaining unhedged and employing options afford the firm with the flexibility to buy yen at the spot rate; this flexibility is not available with a futures contract. Alternative 1 Remain Unhedged Cost in Two Months ($ ,500,000 units) 60,000 Expected Spot Alternative 2 Purchase One Futures Contract Futures Price per Unit Units in Contract 12,500,000 Cost in Two Months ($ ,500,000) 57,600 Alternative 3 Purchase Two Options Options Information Option 1 Option 2 Exercise Price Premium per Unit Units in Contract 6,250,000 6,250,000 Maximum cost: 63, ,250 64,250 66, ,445

26 6. Now assume that you have determined that the historical standard deviation of the yen is about 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 Based on this expectation of the future spot rate, what is the optimal hedge for the firm? Quite obviously the forward rate will be the preferred choicet as it is offering the lowest cost for the lowest risk (see 5). The converted 95% standard deviation is given as x 1.96 = added to the expected rate of = The maximum total bill will therefore be x 12,500,000 = 67,350. The probability of a lower rate than that of the futures option ( ) / = 0.64 of a standard deviation so using tables there is a 32% chance of a lower rate and therefore a 68% chance of a higher rate one would have to be risk loving to prefer this option. Small Business Dilemma Use of Currency Futures and Options by the Sports Extra Company The Sports Exports Company receives pounds each month as payment for the footballs that it exports. It anticipates that the pound will depreciate over time against the dollar. 1. How can the Sports Exports Company use currency futures contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent the Sports Exports Company from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months? 2. How can the Sports Exports Company use currency options to hedge against exchange rate risk? Are there any limitations of using currency options contracts that would prevent the Sports Exports Company from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months? 3. Jim Logan, owner of the Sports Exports Company, is concerned that the pound may depreciate substantially over the next month, but he also believes that the pound could appreciate substantially if specific situations occur. Should Jim use currency futures or currency options to hedge the exchange rate risk? Is there any disadvantage of selecting this method for hedging? Use of Currency Futures and Options by the Sports Exports Company 1. How can the Sports Exports Company use currency futures contracts to hedge against exchange rate risk? Are there any limitations of using currency futures contracts that would prevent the Sports Exports Company from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in each of the upcoming months? The Sports Exports Company can hedge against exchange rate risk by selling futures contracts on pounds. It could use settlement dates that match up with the receivable dates, or could close out the futures contracts at the time the pounds are received. One key limitation is that the number of units for a futures contract is standardized and therefore will not match the exact number of pounds that the Sports Exports Company would need to sell each month.