Financial Hedge | Course Paper

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Answers to End of Chapter 5 Questions

1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts.

ANSWER: 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?

ANSWER: 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?

ANSWER: 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.

ANSWER: 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 $.102 and spot rate is $.10. State whether your answer is a discount or premium.

ANSWER: (F – S) / S

=($.102 – $.10) / $.10 × (360/90)

= .08, or 8%, which reflects a 8% premium

5. Effects of a Forward Contract. How can a forward contract backfire?

ANSWER: 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?

ANSWER: 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.

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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?

ANSWER: 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 in Mexican pesos (assuming the

expiration date and the total dollar value represented by each option are the same for both options)?

ANSWER: 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.

•

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 peso (assuming that the expected volatility of the euro is lower than that of the

peso).

9. Currency Put Option Premiums. List the factors that affect currency put options and briefly explain

the relationship that exists for each.

ANSWER: 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 $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised

was $1.46. Assume there are 31,250 units in a British pound option. What was Randy’s net profit on

this option?

ANSWER:

Profit per unit on exercising the option = $.01

Premium paid per unit = $.02

Net profit per unit = –$.01

Net profit per option = 31,250 units × (–$.01) = –$312.50

11. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for

$.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised

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was $1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net profit on

the option?

ANSWER:

Profit per unit on exercising the option = $.21

Premium paid per unit = $.04

Net profit per unit = $.17

Net profit for one option = 31,250 units × $.17 = $5,312.50

12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per

unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82.

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?

ANSWER:

Premium received per unit = $.01

Amount per unit received from selling C$ = $.76

Amount per unit paid when purchasing C$ = $.82

Net profit per unit = –$.05

Net Profit = 50,000 units × (–$.05) = –$2,500

13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per unit.

The strike price was $.75, and the spot rate at the time the option was exercised was $.72. 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?

ANSWER:

Premium received per unit = $.03

Amount per unit received from selling C$ = $.72

Amount per unit paid for C$ = $.75

Net profit per unit = $0

14. Forward versus Currency Option Contracts. What are the advantages and disadvantages to a U.S.

corporation 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?

ANSWER: 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.

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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?

ANSWER: 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.

16. Hedging with Currency Derivatives. Assume that the transactions listed in the first column of the

following table are anticipated by U.S. 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. Georgetown Co. plans to purchase Japanese goods denominated in yen.

b. Harvard, Inc., sold goods to Japan, denominated in yen.

c. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent.

d. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars.

e. Princeton Co. may purchase a company in Japan in the near future (but the deal may not go

through).

ANSWER:

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 $1.58 and the price on a December futures contract was $1.59. Assume that the pound

depreciated during November so that by November 30 it was worth $1.51.

a. What do you think happened to the futures price over the month of November? Why?

ANSWER: 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 $1.51, the spot rate expected on

the December futures settlement date is likely to be near $1.51 as well.

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.

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ANSWER: You would have sold futures at the existing futures price of $1.59. 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, and fulfill the futures obligation by delivering pounds at

the price of $1.59 per pound.

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?

ANSWER: 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.

ANSWER:

Possible Spot Rate Net Profit (Loss) per

of Canadian Dollar Unit to LSU Corporation

on Expiration Date if Spot Rate Occurs

$.76 –$.02

.78 .00

.80 .02

.82 .04

.85 .07

.87 .09

20. Speculating with Currency Put Options. Auburn Co. has purchased Canadian dollar put options for

speculative purposes. Each option was purchased for a premium of $.02 per unit, with an exercise

price of $.86 per unit. Auburn Co. 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

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deciding whether to exercise the options. In the following table, fill in the net profit (or loss) per unit

to Auburn Co. based on the listed possible spot rates of the Canadian dollar on the expiration date.

ANSWER:

Possible Spot Rate Net Profit (Loss) per Unit

of Canadian Dollar to Auburn Corporation

on Expiration Date if Spot Rate Occurs

$.76 $.08

.79 .05

.84 .00

.87 –.02

.89 –.02

.91 –.02

21. Speculating with Currency Call Options. Bama Corp. has sold British pound call options for

speculative purposes. The option premium was $.06 per unit, and the exercise price was $1.58.

Bama will purchase the pounds 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 Corp. if the

listed spot rate exists at the time the purchaser of the call options considers exercising them.

ANSWER:

Possible Spot Rate at the Net Profit (Loss) per

Time Purchaser of Call Option Unit to Bama Corporation

Considers Exercising Them if Spot Rate Occurs

$1.53 $.06

1.55 .06

1.57 .06

1.60 .04

1.62 .02

1.64 .00

1.68 –.04

22. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a

premium of $.01 per unit, and an exercise price of $.76 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, Inc., if each level occurs and the put options are exercised at that

time.

ANSWER:

Possible Value Net Profit (Loss) to

of Australian Dollar Bulldog, Inc. if Value Occurs

$.72 –$.03

.73 –.02

.74 –.01

.75 .00

.76 .01

23. 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 Foot-

ball 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?

ANSWER: 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 these currencies would continue to strengthen and took large buy