978-1337269964 Chapter 5 Solution Manual Part 1

subject Type Homework Help
subject Pages 9
subject Words 4297
subject Authors Jeff Madura

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POINT/COUNTER-POINT:
Should Speculators Use Currency Futures or Options?
POINT: Speculators should use currency futures because they can avoid a substantial premium. To the
extent that they are willing to speculate, they must have confidence in their expectations. If they have
sufficient confidence in their expectations, they should bet on their expectations without having to pay a
large premium to cover themselves if they are wrong. If they do not have confidence in their expectations,
they should not speculate at all.
COUNTER-POINT: Speculators should use currency options to fit the degree of their confidence. For
example, if they are very confident that a currency will appreciate substantially, but want to limit their
investment, they can buy deep out-of-the-money options. These options have a high exercise price but a low
premium, and therefore require a small investment. Alternatively, they can buy options that have a lower
exercise price (higher premium), which will likely generate a greater return if the currency appreciates.
Speculation involves risk. Speculators must recognize that their expectations may be wrong. While options
require a premium, the premium is worthwhile to limit the potential downside risk. Options enable
speculators to select the degree of downside risk that they are willing to tolerate.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: By comparing futures with options, students should recognize the tradeoff that is formed by the
Answers to End of Chapter 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?
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Currency Derivatives 2
3. Currency Options. Differentiate between a currency call option and a currency put option.
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.
5. Effects of a Forward Contract. How can a forward contract backfire?
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?
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?
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)?
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Currency Derivatives 3
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:
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:
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
was $1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net profit on
the option?
ANSWER:
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:
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:
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Currency Derivatives 4
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
15. Speculating with Currency Futures. Assume that the euros 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?
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
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Currency Derivatives 5
Purchase Sale Futures Futures Calls Puts
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?
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.
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?
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
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Currency Derivatives 6
of Canadian Dollar Unit to LSU Corporation
on Expiration Date if Spot Rate Occurs
$.76 –$.02
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
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
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
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.
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Currency Derivatives 7
ANSWER:
Possible Value Net Profit (Loss) to
of Australian Dollar Bulldog, Inc. if Value Occurs
$.72 –$.03
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?
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
positions in currency futures. However, the Fed intervened in the foreign exchange market by
immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values
of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures
contracts incurred large losses. One prominent trader responded to the effects of the Fed's intervention
by immediately selling 300 futures contracts on British pounds (with a value of about $30 million).
Such actions caused even more panic in the futures market.
a. Explain why the central bank’s intervention caused such panic among currency futures traders with
buy positions.
ANSWER: Futures prices on pounds rose in tandem with the value of the pound. However, when
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Currency Derivatives 8
b. Explain why the prominent trader’s willingness to sell 300 pound futures contracts at the going
market rate aroused such concern. What might this action signal to other traders?
ANSWER: Normally, this order would have been sold in pieces. This action could signal a desperate
c. Explain why speculators with short (sell) positions could benefit as a result of the central bank’s
intervention.
ANSWER: The central bank intervention placed downward pressure on the pound and other European
d. Some traders with buy positions may have responded immediately to the central bank’s intervention
by selling futures contracts. Why would some speculators with buy positions leave their positions
unchanged or even increase their positions by purchasing more futures contracts in response to the
central bank’s intervention?
25. Estimating Profits From Currency Futures and Options. One year ago, you sold a put option
on 100,000 euros with an expiration date of one year. You received a premium on the put option of
$.04 per unit. The exercise price was $1.22. Assume that one year ago, the spot rate of the euro was
$1.20, the one-year forward rate exhibited a discount of 2%, and the one-year futures price was the
same as the one-year forward rate. From one year ago to today, the euro depreciated against the dollar
by 4 percent. Today the put option will be exercised (if it is feasible for the buyer to do so).
a. Determine the total dollar amount of your profit or loss from your position in the put option.
b. Now assume that instead of taking a position in the put option one year ago, you sold a futures
contract on 100,000 euros with a settlement date of one year. Determine the total dollar amount of
your profit or loss.
ANSWER:
26. Impact of Information on Currency Futures and Options Prices. Myrtle Beach Co. purchases
imports that have a price of 400,000 Singapore dollars and it has to pay for the imports in 90 days. It
can purchase a 90-day forward contract on Singapore dollars at $.50 or purchase a call option contract
on Singapore dollars with an exercise price of $.50 to cover its payables. This morning, the spot rate of
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Currency Derivatives 9
the Singapore dollar was $.50. At noon, the central bank of Singapore raised interest rates, while there
was no change in interest rates in the U.S. These actions immediately increased the degree of
uncertainty surrounding the future value of the Singapore dollar over the next three months. The
Singapore dollar’s spot rate remained at $.50 throughout the day.
a. Myrtle Beach Co. is convinced that the Singapore dollar will definitely appreciate substantially
over the next 90 days. Would a call option hedge or forward hedge be more appropriate given its
opinion?
b. Assume that Myrtle Beach uses a currency options contract to hedge rather than a forward
contract. If Myrtle Beach Co. purchased a currency call option contract at the money on Singapore
dollars this afternoon, would its total U.S. dollar cash outflows be more than, less than, or the
same as the total U.S. dollar cash outflows if it had purchased a currency call option contract at
the money this morning? Explain.
ANSWER:
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