International Business Chapter 5 Currency Derivatives Net Profit Per Unit Future Spot Rate The Plotted Points

Currency Derivatives ❖ 16

Net profit per unit

Future spot rate

$1.47

$1.62

$1.53

$1.56

Future spot rate

$1.47

$1.62

$1.53

$1.56

-$.06

$1.47

-$1.47

$.06

Currency Derivatives ❖ 18

Net profit per unit

The break-even points for a strangle where the put option exercise price exceeds the call option

35. Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the

Japanese yen will fluctuate widely against the U.S. dollar in the coming month. Currently, one-month

call options on Japanese yen (¥) are available with a strike price of $.0085 and a premium of $.0007

per unit. One-month put options on Japanese yen are available with a strike price of $.0084 and a

premium of $.0005 per unit. One option contract on Japanese yen contains 6.25 million yen. (See

Appendix B in this chapter.)

a. Describe how Barry Egan could utilize these options to speculate on the movement of the

Japanese yen.

b. Assume Barry decides to construct a long strangle in yen. What are the break-even points of this

strangle?

c. What is Barry’s total profit or loss if the value of the yen in one month is $.0070?

d. What is Barry’s total profit or loss if the value of the yen in one month is $.0090?

ANSWER:

Future spot rate

$.64

$.68

$.65

$.67

-$.01

$.64

Currency Derivatives ❖ 19

b. Lower BE point = $.0084 – ($.0007 + $.0005) = $.0072

c.

Per Unit

Per Contract

Selling Price of ¥

$.0084

$52,500 ($.0084 × 6.25 million units)

– Purchase price of ¥

–.0070

–43,750 ($.0070 × 6.25 million units)

– Premium paid for call option

–.0007

–4,375 ($.0007 × 6.26 million units)

– Premium paid for put option

–.0005

–3,125 ($.0005 × 6.25 million units)

= Net profit

$.0002

$1,250 ($.0002 × 6.25 million units)

d.

Per Unit

Per Contract

Selling Price of ¥

$.0090

$56,250 ($.0090 × 6.25 million units)

– Purchase price of ¥

–.0085

–53,125 ($.0085 × 6.25 million units)

– Premium paid for call option

–.0007

–4,375 ($.0007 × 6.26 million units)

– Premium paid for put option

–.0005

–3,125 ($.0005 × 6.25 million units)

= Net profit

–$.0007

–$4,375 ($.0007 × 6.25 million units)

36. Currency Bullspreads and Bearspreads. A call option on British pounds (₤) exists with a strike

price of $1.56 and a premium of $.08 per unit. Another call option on British pounds has a strike price

of $1.59 and a premium of $.06 per unit. (See Appendix B in this chapter.)

a. Complete the worksheet for a bullspread below.

Value of British Pound at Option Expiration

$1.50

$1.56

$1.59

$1.65

Call @ $1.56

Call @ $1.59

Net

b. What is the breakeven point for this bullspread?

c. What is the maximum profit of this bullspread? What is the maximum loss?

d. If the British pound spot rate is $1.58 at option expiration, what is the total profit or loss for the

bullspread?

e. If the British pound spot rate is $1.55 at option expiration, what is the total profit or loss for a

bearspread?

ANSWER:

a.

Value of British Pound at Option Expiration

$1.50

$1.56

$1.59

$1.65

Call @ $1.56

–$.08

–$.05

+$.01

Call @ $1.59

+$.06

$.00

Net

–$.02

+$.01

Currency Derivatives ❖ 20

c. The maximum gain for the bullspread is limited to the difference between the strike prices less

d.

Per Unit

Per Contract

Selling Price of ₤

$1.58

$49,375 ($1.58 × 31,250 units)

– Purchase price of ₤

–1.56

–48,750 ($1.56 × 31,250 units)

– Premium paid for call option

–.08

–2,500 ($.08 × 31,250 units)

+ Premium received for call option

+.06

+1,875 ($.06 × 31,250 units)

= Net profit

$.00

$0 ($.00 × 31,250 units)

e. A bearspread using these options involves writing the call option with the $1.56 exercise price

and buying the call option with the $1.59 exercise price. At a spot price of $1.55, neither call

option will be exercised, so the bearspreader nets the difference in options premiums.

Per Unit

Per Contract

+ Premium paid for call option

+.08

+2,500 ($.08 × 31,250 units)

– Premium received for call option

–.06

–1,875 ($.06 × 31,250 units)

= Net profit

$.02

$625 ($.02 × 31,250 units)

37. Bullspreads and Bearspreads. Two British pound (₤) put options are available with exercise prices

of $1.60 and $1.62. The premiums associated with these options are $.03 and $.04 per unit,

respectively. (See Appendix B in this chapter.)

b. Complete the following worksheet.

Value of British Pound at Option Expiration

$1.55

$1.60

$1.62

$1.67

Put @ $1.60

Put @ $1.62

Net

c. At option expiration, the spot rate of the pound is $1.60. What is the bullspreader’s total gain or

loss?

d. At option expiration, the spot rate of the pound is $1.58. What is the bearspreader’s total gain or

loss?

ANSWER:

a. Using put options to construct a bullspread involves exactly the same actions as constructing a

b.

Value of British Pound at Option Expiration

Currency Derivatives ❖ 22

40. Uncertainty and Option Premiums. At 10:30 a.m., the media reported news that the Mexican

government‘s political problems had decreased, which reduced the expected volatility of the Mexican

peso against the dollar over the next month. The spot rate of the Mexican peso was $.13 as of 10 a.m.

and remained at that level all morning. At 10 a.m., Hilton Head Co. purchased a call option at the

money on 1 million Mexican pesos with an expiration date one month from now. At 11:00 a.m.,

Rhode Island Co. purchased a call option at the money on 1 million pesos with a December expiration

date one month from now. Did Hilton Head Co. pay more, less, or the same as Rhode Island Co. for

the options? Briefly explain.

41. Speculating with Currency Futures. Assume that one year ago, the spot rate of the British pound

was $1.70, and the one-year futures contract of the British pound exhibited a discount of 6%. At that

time, you sold futures contracts on pounds, representing a total of 1,000,000 pounds. From one year

ago to today, the pound’s value depreciated against the dollar by 4 percent. Determine the total dollar

amount of your profit or loss from your futures contract.

ANSWER: Spot rate 1 year ago = $1.70

42. Speculating with Currency Options. The spot rate of the New Zealand dollar is $.77. A call option

on New Zealand dollars with a one-year expiration date has an exercise price of $.78 and a premium

of $.04. A put option on New Zealand dollars at the money with a one-year expiration date has a

premium of $.03. You expect that the New Zealand dollar’s spot rate will decline over time and will

be $.71 in one year.

a. Today, Dawn purchased call options on New Zealand dollars with a one-year expiration date.

Estimate her profit or loss per unit at the end of one year. [Assume that the options would be

exercised on the expiration date or not at all.]

b. Today, Mark sold put options on New Zealand dollars at the money with a one-year expiration

date. Estimate his profit or loss per unit at the end of one year. [Assume that the options would be

exercised on the expiration date or not at all.]

ANSWER:

43. Impact of Expected Volatility on Currency Option Premiums. Assume that Australia’s central

bank announced plans to stabilize the Australian dollar (A$) in the foreign exchange markets. In

response to this announcement, the expected volatility of the A$ declined immediately. However, the

Currency Derivatives ❖ 23

spot rate of the A$ remained at $.89 on this day and was not affected by the announcement. Likewise,

the one-year forward rate of the A$ remained at $.89 on this day and was not affected by the

announcement. Do you think the premium charged on a one-year A$ currency option increased,

decreased, or remained the same on this day in response to the announcement? Briefly explain.

CRITICAL THINKING

Pricing of Currency Options Review the logic regarding how currency options are priced. Consider a

speculator who plans to purchase currency options for the option at the money on whatever currency has

the lowest premium. He also who plans to sell currency options for the option at the money on whatever

currency has the highest premium. Another speculator uses a strategy of purchasing call options on

Australian dollars at the money whenever the premium is relatively low (compared to the historical

premiums that existed for this type of option) and sells call options at the money on Australian dollars at

the money. Write a short essay describing your opinion about the likely success of these strategies.

ANSWER

The premium charged for currency options that are at the money are highly influenced by the implied

Solution to Continuing Case Problem: Blades, Inc.

1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise

price of $0.00756 or the call option with the exercise price of $0.00792? Describe the tradeoff.

ANSWER: The table shows how the option choices have changed for Blades. If it wants to ensure

paying no more than 5 percent above the spot rate, the option with the exercise price of $0.00756

2. Should Blades allow its yen position to be unhedged? Describe the tradeoff.

Currency Derivatives ❖ 24

ANSWER: Blades could also remain unhedged but given its previous desire to hedge because of the

3. Assume that some speculators attempt to capitalize on their expectation of the yen’s movement over

the two months between the order and delivery dates by either buying or selling yen futures now and

buying or selling yen at the future spot rate. Given this information, what is the expectation regarding

the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.)

ANSWER: If there are speculators who attempt to capitalize on their expectation of the yen’s future

movement, then the expectation of the future spot rate would be equal to the futures rate. For

4. Assume that the firm shares the market consensus regarding the future yen spot rate. Given this

expectation and given that the firm makes a decision (that is, option, futures contract, or remain

unhedged) purely on a cost basis, what would be its optimal choice?

ANSWER: (See spreadsheet attached.) The optimal choice, given the expected future spot rate in

question 3 and given that the decision is made solely on a cost basis, is to purchase one futures

5. Will the choice you made as to the optimal hedging strategy in question 4 definitely turn out to be the

lowest-cost alternative in terms of actual costs incurred? Why or why not?

ANSWER: No, as mentioned in the case, the yen is very volatile and, therefore, the actual costs

incurred may turn out to be lower had the firm employed either an option to hedge the yen payable or

Alternative 1—Remain Unhedged

Expected Spot Rate $ 0.006912

Alternative 2—Purchase One Futures Contract

Currency Derivatives ❖ 25

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Futures Price per Unit $ 0.006912

Units in Contract 12,500,000

Cost in Two Months ($.006912 × 12,500,000) $ 86,400.00

Alternative 3—Purchase Two Options

Options Information Option 1 Option 2

Exercise Price $0.0075600 $0.0079200

6. Now assume that you have determined that the historical standard deviation of the yen is about

$0.0005. Based on your assessment, you believe it is highly unlikely that the future spot rate will be

more than two standard deviations above the expected spot rate by the delivery date. Also assume that

the futures price remains at its current level of $0.006912. Based on this expectation of the future spot

rate, what is the optimal hedge for the firm?

ANSWER: (See spreadsheet attached.) Although the spreadsheet is required, the answer to this

question is intuitive. If the futures rate remains at its current level while the expected spot rate at the

Calculation of Highest Forecasted Spot Rate

Expected Spot $0.006912

Alternative 1—Remain Unhedged

Expected Spot Rate $ 0.007912

Currency Derivatives ❖ 26

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost in Two Months ($.006912 × 12,500,000) $ 86,400.00

Alternative 3—Purchase Two Options

Options Information Option 1 Option 2

Exercise Price $0.0075600 $0.0079200

Solution to Supplemental Case: Capital Crystal, Inc.

This case is designed to give students more insight on the advantages and disadvantages of currency

futures and options. More comprehensive questions on this subject are offered in Chapter 11.

a. To hedge with futures, the cost of the imports will be $795 million ($1.59 × £500 million). To hedge

with call options, the cost per unit (including the premium paid) is $1.61, so that the cost of the

b. Since the future spot rate is likely to exceed the futures price, hedging with futures would likely be less

costly than not hedging. Even if it was more costly, it might be wise to hedge in keeping with the

conservative management style of Capital Crystal, Inc.

Currency Derivatives ❖ 27

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

hedged with a call option. This issue normally generates much discussion. The key question is

whether a manager should take the risk of not hedging. While this strategy is expected to save the firm

$5 million, it could backfire if the pound appreciates over the period (in which case the manager may

be reprimanded). This part of the case attempts to show that hedging is sometimes used even if it is

expected to be more costly than not hedging, because of the desire to avoid risk.

If students put themselves in the position of the managers (bonus is received if a minimum level of

performance is achieved), they would probably hedge. However, it is questionable whether this

strategy would satisfy shareholder wealth. One could argue that there are agency problems, because

managers are forced by the bonus system to avoid risk. Therefore, managers may use more

conservative strategies than what is desired by shareholders in some situations.

This case is realistic, although the name of the firm has been changed. The manager decided to use the

call options in order to avoid risk; based on the firm’s policy, he would not have benefited directly by

not hedging even if it reduced the firm’s costs. There was no real incentive to take any chances.

Small Business Dilemma

Use of Currency Futures and Options by the Sports Exports Company

1. How can the Sports Exports Company use currency futures contracts to hedge against exchange rate

risk? Are there any limitations when using currency futures contracts that would prevent the firm

from locking in a specific exchange rate at which it can sell all the pounds it expects to receive in

each of the upcoming months?

2. How can the Sports Exports Company use currency options to hedge against exchange rate risk?

3. Are there any limitations of using currency options contracts that would prevent the Sports Exports

Company from locking in a specific exchange rate at which it can sell all the pounds it expects to

receive in each of the upcoming months?

4. Jim Logan, owner of the Sports Exports Company, is concerned that the pound may depreciate

substantially over the next month, but he also believes that the pound could appreciate substantially if

specific situations occur. Should Jim use currency futures or currency options to hedge the exchange

rate risk? Is there any disadvantage when selecting this method for hedging?

Currency Derivatives ❖ 28

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ANSWER: Jim may consider purchasing put options, which provide a greater degree of flexibility.

The option provides a hedge if the pound depreciates but does not need to be exercised if the pound

appreciates.

The disadvantage of purchasing put options is that a premium must be paid to purchase the options,

whereas such a premium would not have to be paid when using futures contracts to hedge.

Part 1—Integrative Problem

The International Financial Environment

Mesa Company specializes in the production of small fancy picture frames, which are exported from the

U.S. to the United Kingdom. The firm invoices the exports in pounds and then converts the pounds to

dollars when they are received. The British demand for these frames is positively related to economic

conditions in the United Kingdom. Assume that British inflation and interest rates are similar to the rates

in the U.S. Mesa believes that the U.S. balance-of-trade deficit from trade between the U.S. and the

United Kingdom will adjust to changing prices between the two countries, while capital flows will adjust

to interest rate differentials. Mesa believes that the value of the pound is very sensitive to changing

international capital flows and is moderately sensitive to international trade flows. Mesa is considering

the following information:

• The U.K. inflation rate is expected to decline, whereas U.S. inflation rate is expected to rise.

• British interest rates are expected to decline, whereas U.S. interest rates are expected to increase.

1. Explain how the international trade flows should initially adjust in response to the changes in inflation

(holding exchange rates constant). Explain how the international capital flows should adjust in

response to the changes in interest rates (holding exchange rates constant).

2. Based on the information provided, will Mesa expect the pound to appreciate or depreciate in the

future? Explain.

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Mesa believes international capital flows shift in response to changing interest rate differentials. Is

there any reason why the changing interest rate differentials in this example will not necessarily cause

international capital flows to change significantly? Explain.

4. Based on your answer to question 2, how would Mesa’s cash flows be affected by the expected

exchange rate movements? Explain.

5. Based on your answer to question 4, should Mesa consider hedging its exchange rate risk? If so,

explain how it could hedge using forward contracts, futures contracts, and currency options.