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 should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of $0.00792, but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firm¶s desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer, or a higher exercise price that limits the effectiveness of the hedge. If it decides to use an option, the tradeoff is paying a premium of $1,417.50 to limit the payables amount to $99,000 or paying a premium of $1,890 to limit the payables amount to $94,500. The preferred option depends on the firm¶s assessment about the yen, but many analysts would select the higher premium (an extra $472.50) to pay for the lower limit on payables. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff.

ANSWER: Blades could also remain unhedged, but given its previous desire to hedge because of the volatile movements even before the event, it would have an even stronger desire to hedge once the event caused more uncertainty about the yen¶s future value. Since futures prices were not affected by the uncertainty-increasing event, Blades should seriously consider futures contracts as an alternative to options. Thus, the firm could purchase a futures contract and lock in its future payment at the same futures price as before the event. 3. Assume there are speculators who 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 on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.)

all speculators will engage in similar actions. then the expectation of the future spot rate would be equal to the futures rate. 5. as mentioned in the case. Although remaining unhedged also has an expected cost of $86.) The optimal choice. which would result in an actual cost on the delivery date of $86. is to purchase one futures contract. They would buy yen futures now.006912. If the yen appreciates. which locks the firm into the price it will pay to buy the yen at the delivery date. actual costs incurred on the delivery date to purchase yen may deviate substantially from this value. remaining unhedged and employing options afford the firm with the flexibility to buy yen at the spot rate. the firm forgoes any cost advantage that may result from a substantial depreciation of the yen by the delivery date. this flexibility is not available with a futures contract. therefore. For example.. the expected spot rate at the delivery date is equal to the futures rate. Assume that the firm shares the market consensus of the future yen spot rate. the yen is very volatile and. what would be its optimal choice? ANSWER: (See spreadsheet attached. Thus. the firm will probably prefer using a futures contract over remaining unhedged. Given this expectation and given that the firm makes a decision (i. futures contract. By employing a futures contract to hedge. This process continues until the futures rate is equal to the expected future spot rate. . Consequently. if the market expectation is that the yen will appreciate.400.ANSWER: If there are speculators who attempt to capitalize on their expectation of the yen¶s future movement. they will buy the yen at the futures rate in two months and sell them at the spot rate prevailing at that time. remain unhedged) purely on a cost basis.400.e. which would place upward pressure on the futures rate and downward pressure on the expected future spot rate. Therefore. In that case. 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. option. depending on the movements of the yen between the order date and the delivery date. the actual costs incurred may turn out to be lower had the firm employed either an option to hedge the yen payable or remained unhedged. 4. given the expected future spot rate in question 3 and given that the decision is made solely on a cost basis. $0. suppose speculators expect the yen to appreciate.

500.417.000 $ 86.000) $ 0. Exercise Price of $.653.400.Alternative 1²Remain Unhedged Expected Spot Rate Amount of Yen Payables Cost in Two Months ($.500.00 $88. Exercise Price of $.0001512 6.400.50 $1.0075600 $0.250.000 Column C Amount Paid Total Premium (Premium per unit v Units) Two Options.500.006912 × 12.0079200 $0.000 units) $ 0.75 O1-No.400.250.75 $1.50 No $86.00 Alternative 2²Purchase One Futures Contract Futures Price per Unit Units in Contract Cost in Two Months ($.0001134 6.00756 Two Options.00 No $86.00 Alternative 3²Purchase Two Options Options Information Exercise Price Premium per Unit Units in Contract Calculations Column A Column B Option 1 $0.400.006912 12.500.006912 12.000 $ 86.400. O2-No $86.817.00 $88.000 Column D .00792 One Option of Each Exercise Price $1.290.053.006912 × 12.890.00 Exercise? (Is Spot Rate > Exercise Price?) for Yen (Exercise Price v Units) Total Paid (Column A + Column C) Option 2 $0.00 $87.

00 .500.0005. Based on this expectation of the future spot rate.006912 × 12.) Although the spreadsheet is required. 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.00756 would now be exercised.007912 12. However.500. the option with the exercise price of $0.900.500.007912 $0. what is the optimal hedge for the firm? ANSWER: (See spreadsheet attached.500.400.6.007912 × 12.006912 + [2 × 0.000500 Alternative 1²Remain Unhedged Expected Spot Rate Amount of Yen Payables Cost in Two Months ($. Calculation of Highest Forecasted Spot Rate Expected Spot Standard Deviation Spot Rate if Yen Increases 2 Standard Deviations ($. Now assume that you have determined that the historical standard deviation of the yen is about $0. the futures contract is again the best alternative for the firm.006912 12. and since the expected future spot rate is greater than the futures rate.000) $ 0. Based on your assessment.006912.000) $ 0. remaining unhedged will become more expensive than hedging with a futures contract (recall that the two alternatives have the same expected cost). Also assume that the futures price remains at its current level of $0.00 Alternative 2²Purchase One Futures Contract Futures Price per Unit Units in Contract Cost in Two Months ($. Nevertheless.000 $ 86.006912.000 $ 98. the answer to this question is intuitive.006912 0.0005]) $0. as the spreadsheet shows. If the futures rate remains at its current level while the expected spot rate at the delivery date increases. since both options have an exercise price greater than the futures rate of $0.

00 Exercise? (Is Spot Rate > Exercise Price?) for Yen (Exercise Price v Units) $94.353.500.50 $1.0001512 6.00 No $98.Alternative 3²Purchase Two Options Options Information Exercise Price Premium per Unit Units in Contract Option 1 $0.000 Option 2 $0.00756 Two Options.0079200 $0.75 .700.00 $98. Exercise Price of $.900.390.417.250. Exercise Price of $.00 Total Paid (Column A + Column C) Yes $96.250.317.00 $100.75 $1.00792 One Option of Each Exercise Price $1.50 O1-Yes. O2-No $96.000 Calculations Column A Column B Column C Amount Paid Column D Total Premium (Premium per unit v Units) Two Options.890.0001134 6.0075600 $0.653.

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