Case_Study

Case Study The foreign exchange rate is the cost when two or more currencies are exchanged. An open price is set by investors and can fluctuate on a daily basis. Some nations will not openly trade their currencies these are not able to be purchased by investors and are at a set value. Currency depreciation occurs when the price of one currency falls in relation to another. While a currency is depreciating against one currency it is possible for that same currency to appreciate against another. The changes in value of the currency are directly related to the supply and demand placed on that currency by investors. The supply and demand for any specific currency will depend on three factors the first is the exchange rate (About.com, 2011). The higher the exchange rate the smaller the demand is for that currency in the foreign exchange market. This is because it will cost more to convert that currency from one to another, the smaller the possible profit from that exchange. The opposite is true of a smaller exchange rate for a currency the larger the profit. The exchange rate will also affect the value of exports from that nation. If the exchange rate is too large the demand for products from that nation will fall or the prices must decrease for that product to remain competitive in the market. The next part that will affect supply and demand is the interest rate. The smaller the difference in interest rates the smaller the demand for assets will be from that nation with the smaller interest rate. This translates into a smaller demand for currency from that nation. The final piece of the puzzle is the expected future exchange rate. The higher the expected future exchange rate the smaller the quantity supplied and the higher the quantity that will be demanded for that currency. The way Blades Inc. conducts business requires it to enter into many different business transactions between nations other than the one where it is headquartered. This includes currencies such as the Japanese yen. Since Blades Inc. conducts so many foreign transactions the organization is at substantial risk for potential loss. Since Blades conducts many out of country transactions there will be loss at sometime, the job of the financial officers of the company are to minimize those risks and losses. A currency hedge is the usual strategy to reduce risk involved in foreign currency transactions. 12.5 million yen is a large risk for Blades Inc. and the potential losses need to be minimized. A future contract is a contract to buy or sell a product or asset at a set price; in this case the product is Japanese yen. Futures contracts are traded in an open exchange market. The other option to reduce risk is called an option. An option would give the Blades the right but not the obligation to buy or sell an asset again this would be Japanese yen. The best option for the Blades Inc. would be to purchase 12.5 million yen in 2 months. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $.00756 or the call option with the exercise price of $.00792. Describe the tradeoff. Option $0.00756 Total cost per yen = $0.00756 + $0.0001512 = $0.0077112 Forward rate = ($0.0077112-$0.0072)/$0.0072 = 0.071 Annual forward rate = (1+0.071)^6-1 = 50.92% Option $0.00792 Total cost per yen = $0.00792 + $0.0001134 = $0.0080334 Forward rate = ($0.0080334-$0.0072)/$0.0072 = 0.11575 Annual forward rate = (1+0.11575)^6-1 = 92.93% The proper choice for Blades Inc is to use a call option with a price of $.00756. This would have a lower forward rate; however, there would be a higher premium paid for this option which still may or may be exercised. In this option the premium that was paid would be shown as a lost cost. Should Blades allow its yen position to be un-hedged' Describe the tradeoff. Blades Inc. should not allow its yen position to be un-hedged. Given the relative large gap between the premiums of existing call options, the US dollar-yen exchange rate is volatile in the short term. Hedging the yen position commits a cash outflow equal to the premium payment that would result to a loss if after two months, that the price of yen in United States dollars is lower than the exercise price of the option. Not hedging the position also risks the Blades would need more United States dollars to cover its 12.5 million yen liability. This is higher than the exercise price and the premium paid for the option. 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.) The expected yen spot rate on the delivery date is the same as the futures price of $.006912. 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 un-hedged) purely on a cost basis, what would be its optimal choice' Blades, Inc.'s best choice would be to remain un-hedged which has no cost compared to $1,890 and $1,417.50 for the options with exercise prices of $0.00756 or $0.00792. Option $.00756 $.00792 Un-hedged futures. Cost $1890 $1417.5 $0.0 $86,400 Question 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' The lowest cost alternative is the not the same as the optimal hedging strategy in question 4 which was to remain un-hedged. If the spot rate at the date of delivery is any number above the futures price, then the optimal alternative would be the futures with a total cost of $86,400. The total cost of the un-hedged option would be equal to the spot price at the date of delivery multiplied by 12.5 million yen. The un-hedged strategy is the optimal in terms of total costs if the spot rate at the date of delivery is lower than $0.006912. Option $.00756 $.00792 Un-hedged Futures Premium cost $ 1890 $1417.50 $0 $0 Cost of Yen $94,500 $ 99,000 $86,400 Actual cost $96,390 $100,417.50 $86,400 Question 6 Now assume that you have determined that the historical standard deviation of the yen is about $0.0005. 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 $0.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm' The estimate of the standard deviation the expected spot rate for the yen in two months ranges between $.005912 and $.007912. Looking at the range the option with the exercise price of $.00792 has been excluded from the options. Looking at the expected spot rate and potential gains or losses an option with the exercise price $.7912 is the option with the lowest possible loss of $1890, compared to a potential loss of $12,500 with the futures option. Standard deviation $.0005 Expected future price $.006912 Two standard deviation $ .0010 Lower bond $.005912 Upper bond $.007912 Spot price in two months $ .005912 $.006912 $.00756 $.007912 Premium cost - option @ $.00756 $1890 $1890 $1890 $1890 Expected gain or loss -$1890 -$1890 $0 $2510 Futures Expected gain -$12,500 $0 $8,100 $12,500 Reference: About.com. (2011). Supply & Demand: How They Move Currencies. 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