Q4. (25%) Suppose you have business operation in scenario (A) and (B) as bellow.
ID: 2784093 • Letter: Q
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Q4. (25%) Suppose you have business operation in scenario (A) and (B) as bellow. Please describe yoedging strategy by using (1) future contracts and (2) option contracts. (Suppose future and option contracts are available in the market.) (A) You are owning three famous restaurant chain brand names in five Asia countries. All incomes are converted to U.S. dollar at the end of each month. At the end of each year, you will convert all U.S. dollar dominated income to your home currency. However, you are very concern about the possible volatility of exchange rate between the U.S. dollar and your home currency (B) You are managing five major brand ski gears (skis, boots...etc.) assembly facilities in your country. However, major parts of thase ski gears are imported from Europe and you pay Euro () to your parts suppliers at the end of each year. Due to the significant weight of those parts in your cost structure, you are concerning about the possible volatility of exchange rate between the Euro (E) and your home currency Bonus question)(15%) (With the completion of Q1 to Q4, feel free to answer this bonus question for extra 15% grades.) Choose an industry and apply the Porter's Five Forces framework to: (A) analyze the competitive advantage in an industry, and (B) identify which firms in this industry might be best positioned for successExplanation / Answer
A4.
(A) If I am holding three famous restaurant chain brands in five different countries then my best strategy for hedging would be use the options contract. The options contract helps in hedging risks arising due to exchange rate fluctuations arising over a period of time. If I have chain brands in five different countries and at the end of each month and at the end of the year if I am required to convert the local currency of each country into US dollars and back into the local currency at the end of the month, then the risk my business is facing is due to fluctuating exchange rates between the US dollars and all the five local currencies over a period of time.
Options are a contract between two parties to buy or sell specific asset, at a specific price at a specified future date. However, as the name suggests, the parties to the contract have the option to exercise the agreement at the future date and are under no obligation to do so. The right to buy in the future is called a call option and the right to sell is called the put option.
In the scenario A it would be beneficial for my company if the value of the US dollars continuously increases over the year against my local currency so that at the end of the year I receive more local currency than what I had converted each month. In order to ensure this I would sell call option if I expect US dollar to appreciate or buy put option if I expect US dollars to depreciate.
(B) In case I am managing five major brands ski gears, purchases for which is made from Europe and assembly only of which is done in my country, then the risk I want to hedge against is the risk of rise in prices of material I purchase from Europe due to fluctuating exchange rates between Euro and my home currency. Because if Euro becomes stronger against my home currency the price of the material purchased from Europe, which is a significant part of my total product cost will also increase significantly, thereby directly squeezing my margins.
For this purpose I would enter into a long futures contract for purchase of specific quantity of material at a specific price at a certain future date. A futures contract is a binding agreement between two parties to buy or sell a specific asset, at a specific time, at a specified price. A long future contract is entered into when the buyer expects the price of the material he intends to buy in the future to increase. By doing so I will be able to lock the price at which I will be buying the required quantity of material at a required future date. This will protect my business against price fluctuations in raw material resulting from exchange rate fluctuations.
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