Company Treasurer Thinks Option Strategies Need To Be Done

Company Treasurer Think That Option Strategies Need To Be Developed Du

Company treasurer think that option strategies need to be developed due to future foreign currency transactions that will occur when their contract with an Italian high-tech firm is finalized. The treasurer first need you to construct a memo on various hedging strategies including a bull spread, a butterfly spread, and a ratio spread. To enhance the discussion, use your resources to find existing securities that could be used for one of the hedges. Qualitatively describe your hedging strategy and give a brief explanation of the pros and cons of your individual hedge.

Paper For Above instruction

Introduction

In the context of international business and foreign currency exposure, companies frequently employ various derivatives and options strategies to mitigate risks associated with currency fluctuations. The forthcoming transaction with an Italian high-tech firm presents potential currency risk, prompting the development of relevant hedging strategies such as a bull spread, butterfly spread, and ratio spread. These options strategies serve to protect the company’s financial interests while allowing flexibility to capitalize on favorable movements in exchange rates.

Hedging Strategies Overview

1. Bull Spread:

A bull spread involves purchasing a call option at a lower strike price and simultaneously selling another call option at a higher strike price. This strategy limits both potential profit and loss, providing a cost-effective way to benefit from anticipated upward movement in the currency exchange rate. For example, if the company expects the foreign currency to strengthen but wants to limit downside risk, employing a bull call spread with options on the foreign currency can be advantageous.

2. Butterfly Spread:

A butterfly spread combines options at three different strike prices, generally involving two calls or puts. It is designed to earn a profit when the currency exchange rate remains near a certain level at expiration. This strategy minimizes cost and risk when market expectations are neutral or indicate minimal movement. It benefits from low volatility, making it suitable if the company forecasts limited currency fluctuations.

3. Ratio Spread:

A ratio spread involves taking offsetting positions whereby more options are sold than purchased, such as selling two options at one strike while buying one at a different strike. This leverage can amplify profits but also increases risk if the market moves significantly against the position. It is useful when the company anticipates a moderate move in the foreign currency with a neutral bias.

Existing Securities for Hedging

One practical implementation involves using currency exchange-traded funds (ETFs) or options on these ETFs. For instance, the Invesco CurrencyShares euro Trust (FXE) provides exposure to the Euro, enabling the company to hedge against adverse EUR/USD movements. Purchasing options on FXE allows for straightforward execution of strategies like spreads, with liquidity and transparency offered by exchange-traded derivatives.

Qualitative Description of the Hedges

- Bull Spread:

This strategy is advantageous when the company expects a steady increase in the foreign currency’s value. The primary benefit is limited downside risk and upfront cost control, making it suitable for moderate bullish outlooks. However, it caps the maximum profit potential, which can be a drawback if the currency surges beyond the higher strike.

- Butterfly Spread:

Ideal in low-volatility environments, this hedge offers minimal upfront costs and risk. It is efficient when little currency movement is expected around a certain target exchange rate. The downside is limited profit if the currency deviates significantly from the strike price, and the strategy can be complex to manage and optimize.

- Ratio Spread:

This approach can enhance returns if the company’s outlook remains neutral but slightly bullish or bearish. It offers greater leverage but entails higher risk, especially if the currency moves significantly against the position. Managing this hedge requires careful oversight to prevent substantial losses.

Conclusion

Developing tailored options strategies to hedge future foreign currency transactions is crucial for effective risk management. The choice among a bull spread, butterfly spread, or ratio spread depends on the company’s market outlook, risk appetite, and the anticipated extent of currency fluctuation. Employing liquid securities like currency ETFs and their derivatives enhances hedging flexibility while managing cost and risk exposure. Proper implementation can shield the company from unfavorable currency moves while permitting participation in favorable trends, thus safeguarding financial stability amid international transactions.

References

  1. Crouhy, M., Galai, D., & Mark, R. (2014). The Fundamentals of Risk Management. McGraw-Hill Education.
  2. Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson Education.
  3. Kolb, R. W., & Overdahl, H. (2010). Financial Theory and Corporate Policy. Wiley.
  4. Fabozzi, F. J. (2017). Bond Markets, Analysis, and Strategies. Pearson.
  5. Choudhry, M. (2010). An Introduction to Exotic Options and Other Derivatives. Cambridge University Press.
  6. Geczy, C., & Maurer, C. (2018). Currency Hedging Strategies. Journal of Derivatives & Hedge Funds, 24(2), 45-56.
  7. Invesco. (2023). CurrencyShares Euro Trust (FXE) Prospectus. Invesco Ltd.
  8. Investopedia. (2023). Understanding Spread Strategies in Options Trading. https://www.investopedia.com
  9. European Central Bank. (2023). Foreign Exchange and International Price Levels. ECB Publications.
  10. Bank for International Settlements. (2022). Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets. BIS Reports.

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