Devising Hedging Strategies The Assignment You are a member of Chase Options, In
ID: 2776292 • Letter: D
Question
Devising Hedging Strategies
The Assignment
You are a member of Chase Options, Inc., who was asked to participate in designing hedging strategies for the following transactions:
' Anticipated Currency Transactions
1.) A U.S. company expects DM 100 million in repatriated profits from its German subsidiary on March 20, 1991. The company believes that the dollar has reached a long-term low at the current level DM/$1.6700; however, it doesn't want to lock in a forward exchange contract because of uncertainty concerning the impact of the German reunification on the currency market. The company doesn't want to exchange at greater than DM/$1.7000 (e.g., 1.7200). Design a hedging strategy by using currency options and utilizing the rates available in Table 1 (Row 1). Examine the implications of hedging instead with a forward contract.
2.) A U.S. firm has bought industrial equipment from a U.K. firm for £5 million payable in 60 days. The firm believes that U.K.'s political and economic uncertainty might drive the pound sterling down significantly. Design a hedging strategy for the corporation by employing either forward currency contracts or currency options and utilizing the data listed in Table 1 (Row 3).
Explanation / Answer
Answer (1)
Expected Amount of repatriated profits = DM 100 Million on 20 March, 1991
Spot rate = DM 1.6700/$ Forward Rate = DM 1.6725 / $
The company can enter into a forward contract to sell DM at 1.6725
or
The company has a choice to hedge expected inflows by buying a put option at a strike price of DM 1.7/$. The premium is $ 0.0466. The Delta of this option is 0.3387. That is for a change in DM value the $ value changes 0.3387. To hedge this option, since we are selling DM, we need to borrow DM equivalent to 0.3387 of the total asset such that the changes in DM/$ price are offset.
Let us say that DM / $ rate on the date of maturity is 1.7200
As spot rate is lower than option strike price, option is exercised
Firm sells DM 100 Million at DM 1.70 / $ and receives = DM 100 Million / 1.70 = $ 58.824 Million
Premium paid for purchase of the put option is $ 0.0466 = DM 100,000,000/1.67 * 0.0466 = $ 2.79 Million
Net Amount Received by the firm = $ 58.824 Million - $ 2.79 Million = $ 56.034 Million
By hedging the expected cash inflow of DM 100 Million the company can anticipate an amount of $ 56.034 Million on March 20, 1991.
If the rate on March 20,1991 was at DM 1.6725 (same as forward rate), the option will be allowed to expire and the firm will sell DM in the market at the spot rate of 1.6725 and receive $ 59.7907 Million
Net Amount Receivable = $ 59.7907 Million - $ 2.79 Million (Option Premium) = $ 57.001 Million
Thus by hedging operations using options the firm can lock its net receivables around $ 55.444 Million. At any rate above the strike price the option would be allowed to expire and the firm sells in the spot market for a higher profit.
However if the firm purchases a forward contract, it needs to deliver the Foreign currency on March 20, 1991 at 1.6725 irrespective of the spot price. Thus its net flows are locked at DM 100 Million / 1.6725 = $ 59.7907 Million and any further improvement will not have any impact on the cash flows.
Based on the above, if the Foreign currency is expected to weaken in future with a receivable from in that currency, options will limit the exposure on the lower side.
Answer (2)
Firm has a payable of GBP 5 Million in 60 days.
Current Spot Rate = 1.7 and forward rate = 1.6818
Firm purchases a forward contract at $ 1.6818 / GBP
Net Payable after 60 days = GBP 5 Million * 1.6818 = $ 8.409 Million
Say future spot rate of GBP is 1.7
Net Payable after 60 days = GBP 5 Million * 1.7 = $ 8.5 Million
Say future spot rate of GBP is 1.72
Net Payable after 60 days = GBP 5 Million * 1.72 = $ 8.6 Million
Buy a call option at a strike price of $1.7/GBP
If future spot rate is 1.6818
Option is allowed to expire
Buy at spot rate = GBP 5 Million * 1.6818 = $ 8.409 Million
Option Premium = 0.006105 * 8.5 = $ 0. 0518925 Million
Net Payable = $ 8.461 Million
If future spot rate is 1.72, option is exercised
Buy at 1.7 = GBP 5Million * 1.70 = $ 8.5 Million
Option premium = 0.006105 * 8.5 = $ 0.0518925 Million
Net Payable = $ 8.552 Million
Thus the firm could limit its exposure to $ 8.552 Million. If the rates are higher than the strike price, the option is allowed to expire and foreign currency is purchased from spot markets to pay the amount payable.
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