A Japanese importing firm is expected to make payment of ?2.5 million in 180 day

Question

A Japanese importing firm is expected to make payment of ?2.5 million in 180 days. The firm can handle its open position in £ using the following methods: Method 1: Use a 180-day forward contract with a forward ¥/£ exchange rate of 210.45. Method 2: Use a 180-day option on £ with an exercise price of ¥208.75 per £ and a premium of ¥1.45 per £. (Note: Be sure to state what kind of option on £ the firm used) Method 3: Do nothing. Note: Show your work and keep you answers to 4 decimal points if necessary. Be sure to show your work. a) If the (spot) ¥/£ exchange rate 180 days from now were 209.65, which of the above methods should the firm adopt if it wants to minimize the amount of payment made? Find the total amount of ¥ paid? Be sure to explain what kind of forward and option options on ? the firm used to eliminate its open position. (15 points) b) What would be the maximum amount of ¥ (per £) paid in 180 days? Explain. (5 points) c) Will the firm ever use Method 1 to handle its open position? Yes/No, explain. (5 points)

Explanation / Answer

Payment to be made is GBP 2.5 million in 180 days. This will mean buying pounds and selling yen.

(i) Forward rate Yen / GBP 210.45 - the company can lock into the rate of conversion of yen to pounds by selling yen 180 day forward at 210.45 for every 1 pound - its another way of saying that the companyhas bought forward pound at 210.45 yen per 1 pound. The total outflow under this option, irrespective of the spot rate , will be = 210.45 * 2,500,000 = JPY 526,125,000

(ii) 180 day option : Since the company has to buy pounds, it will purchase a call option on pounds with exercise price of JPY 208.75 per pound i.e. it has guaranteed it self maximum price of pound in yen terms to 208.75. For any increase beyond this level, it will be safe and for purchasing this right to convert at this price, the company is paying a premium of yen 1.45. Hence the net price for the company will be (208.75+1.45) = JPY 210.2 per 1 pound. Note if the exhange rate is above the exercise price, it will be beneficial to use the option and if the exchange rate is below 208.75, the company can use the spot rate and let the option expire. The maximum outflow in terms of yen will be (2500000 * 210.2) = JPY 525,500,000

(iii) Do nothing option: This is the riskiest option since the exchange rate can move either way. In this case since the rate is at 209.65 - which is lower than the forward rate and net option cost - it will be the most beneficial option (however note that there is no way of knowing the spot rate upfront hence this is risky). Total outflow = 2500000 * 209.65 = 524,125,000

Since the spot rates are unknown upfront, a firm looking to hedge will look to lock in rates either through forward or options route. On the relative cost and merit basis since the options are cheaper and they come with right to use and not obligation, they will be preferable to forward rate contracts

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