Cabal, Jessa Mae C.

BSBA-FM-4A

Activity 2

1. What are the advantages of a currency options contract as a hedging tool

compared with the forward contract?

One of the advantages of currency options over forward contracts is its flexibility
since I can customize it to meet my specific needs as a hedger, such as contract size,
strike price, and expiration date. With options, I have the right to exercise or not the
contract based on market conditions. I can let the option expire and execute the spot
transaction at a better rate if the exchange rate changes in my favor. Additionally, the
maximum loss is limited to the option premium. In contrast, the forward contract value is
at risk if the exchange rate moves against the hedger.

2. Suppose your company has purchased a put option on the euro to manage
exchange exposure associated with an account receivable denominated in that
currency. In this case, your company can be said to have an “insurance” policy on
its receivable. Explain in what sense this "insurance" is so.

A put option is like insurance for my company. It gives me the right, but not the
obligation, to sell Euros at a set price within a specific time frame. If my company buys a
put option on the euro, it's like buying insurance in case the euro loses value against the
US dollar. If that happens, my company can use the put option to sell Euros at the
agreed price, ensuring a profit.

In this sense, the put option can be thought of as an insurance policy on the
receivable. If the euro loses value, I can still get the entire amount in US dollars, even if
the original amount was in Euros.
 3. IBM purchased computer chips from NEC, a Japanese electronics company, and
was billed ¥250 million payable in three months. Currently, the spot exchange rate
is ¥105/$ and the three-month forward rate is ¥100/$. The three-month money
market interest rate is 8% per annum in the United States and 7% per annum in
Japan. The management of IBM decided to use a money market hedge to deal with
this yen payable.

a. Explain the step-by-step process of a money market hedge for this foreign
currency payable. Compute for the dollar cost of meeting the yen
obligation, and present the amounts involved in each step.

1. IBM borrows $2,380,952.38 in the United States

Spot exchange rate: ¥105/$
¥ Payable in 3 months: 250 million
= 250,000,000 ¥ / 105 ¥/$
= $2,380,952.38

Three-month money market interest rate in the US: 8% per annum

= $2,380,952.38 * (8% / 12) * 3/12
= $55,273.44

2. IBM invests the $2,380,952.38 in Japan

Three-month money market interest rate in Japan: 7% per annum
= $2,380,952.38 * (7% / 12) * 3/12
= $50,461.55

3. In three months, the yen investment will be worth $2,435,323.93

¥ invested in Japan * (1 + interest rate)
= $2,380,952.38 * (1 + 7% / 12)
= $2,435,323.93

The dollar amount of the yen investment in three months is $2,435.32

¥ Investment in Japan / forward rate
= 2,435,323.93/100¥/
= $2,435.32

4. IBM uses this amount to repay the US loan, plus interest of $55,273.44
= $2,380,952.38 + $55,273.44
= $2,436,225.82

5. Therefore, the dollar cost of meeting the yen obligation is $2,436,225.82

By using a money market hedge, IBM is locking in the dollar cost of meeting its yen obligation.
This means that IBM will not be exposed to any losses if the yen weakens against the dollar in
the next three months.