Mr. Curtis Was Enlightened By The Information You Provided.

Mr Curtis Was Enlightened By The Information You Provided But Would L

Mr. Curtis was enlightened by the information you provided but would like to learn if there are alternative methods available for dealing with currency risks. He requests that you research material from the Library and/or the Internet to construct a memo of 2–3 pages on the differences between buying a call option, selling a call option, buying a put option, and selling a put option. Also, give an example of a business scenario in which it would be appropriate to use each of the contracts (a put and a call contract). If, instead, you chose to use the forward market, assume you were going to receive 100,000 Japanese yen in 6 months, and the current exchange rate is 5 yen to 1 U.S. dollar. How many yen would you sell or buy in the forward market? Be sure to cite all references using the appropriate citation format.

Paper For Above instruction

Introduction

Currency risk management is an essential component for multinational corporations and investors operating in the global economy. Fluctuations in exchange rates can significantly impact financial outcomes, making it crucial to employ effective hedging strategies. Traditional methods include forward contracts, options, and other derivatives, each with unique features and applicability depending on the specific circumstances. This paper explores the differences between buying and selling call and put options, provides practical business scenarios for their use, and examines how forward contracts can serve as an alternative method to hedge currency risks, exemplified through the case of Japanese yen receivables.

Understanding Currency Options

Currency options are financial derivatives that confer upon the holder the right, but not the obligation, to buy or sell a specified amount of foreign currency at a predetermined exchange rate (the strike price) within a set period. The primary types of options relevant to currency hedging are calls and puts, each with buying and selling strategies.

Buying a Call Option

A call option provides the right to purchase foreign currency at a specified strike price before expiration. An entity might buy a call option when it anticipates the foreign currency will appreciate, but wants protection against adverse movements. For example, a U.S.-based company expecting to pay a large invoice in euros in three months might buy a euro call option to lock in a maximum purchase price, hedge against euro appreciation, and retain upside potential if the euro depreciates.

Selling a Call Option

Selling a call option obligates the seller to deliver foreign currency at the strike price if the option is exercised, typically receiving a premium upfront. This strategy suits situations where the seller predicts the foreign currency will depreciate or stay flat. For instance, a firm with surplus foreign currency may sell call options to generate income, betting the currency will not rise beyond the strike price, thus limiting potential gains but providing immediate premium income.

Buying a Put Option

A put option grants the right to sell foreign currency at a set strike price, safeguarding against depreciation. A practical scenario involves an importer planning to pay a foreign supplier in three months who fears that the foreign currency might weaken. Buying a put option allows the importer to lock in a minimum exchange rate, reducing the risk of unfavorable currency movement.

Selling a Put Option

Sellers of put options agree to buy foreign currency at the strike price if exercised. This position is advantageous if the individual anticipates the foreign currency will remain stable or appreciate. For example, a multinational with excess foreign currency holdings might sell put options to earn premiums, expecting the currency to stay above the strike price, and be willing to buy more at that level if exercised.

Business Scenarios for Currency Options

Each type of option serves distinct strategic purposes:

- Buying a Call Option: A U.S. firm purchasing equipment from Europe might buy a call option to hedge against euro appreciation, ensuring predictable costs.

- Selling a Call Option: A company with excess foreign currency can sell calls to generate income, such as an exporter expecting to earn euros, betting the euro won't rise significantly.

- Buying a Put Option: An importer with foreign payables may buy puts to secure a minimum purchase rate, avoiding losses if the foreign currency depreciates.

- Selling a Put Option: A business holding foreign currency assets might sell puts to earn premiums, accepting the risk of buying additional currency if prices fall.

Using Forward Contracts as an Alternative

Alternatively, some firms prefer forward contracts, which are agreements to buy or sell foreign currency at a fixed rate on a specified future date. Consider a company expecting to receive 100,000 Japanese yen in six months, with the current exchange rate at 5 yen per U.S. dollar.

Since the company expects to receive yen, it would enter a forward contract to sell yen, locking in an exchange rate to mitigate currency risk. To determine the forward rate, firms typically use the interest rate parity (IRP) theory, which relates spot and forward rates to the interest rates in the respective countries. Assuming the forward rate aligns closely with the current spot rate adjusted for interest rates, the company would agree to sell 100,000 yen at a rate close to 5 yen per U.S. dollar.

Consequently, the firm would exchange its yen for U.S. dollars at this predetermined rate, protecting against yen depreciation. If the yen weakens against the dollar, the firm avoids lower receivables, but if yen appreciates, it potentially forfeits some gains but benefits from certainty in cash flows. This mechanism reduces exchange rate volatility and simplifies financial planning.

Comparison of Methods

While both options and forwards serve to hedge currency risk, they differ fundamentally. Options offer flexibility, allowing the holder to choose whether to execute the contract based on market movements, but involve premiums and higher costs. Forward contracts are straightforward and cost-effective but lack flexibility; they obligate the parties to transact at the agreed rate regardless of market fluctuations. The choice depends on the company's risk appetite, market outlook, and cost considerations.

Conclusion

Managing currency risk is vital for international business operations. Currency options provide versatile strategies tailored to various risk scenarios, offering both protection and potential gains in favorable market conditions. Forward contracts serve as a more straightforward hedge, locking in exchange rates for future transactions at a predictable cost. The decision to use options or forwards should consider the specific business context, risk tolerance, and market outlook. By understanding these instruments' mechanics and appropriate scenarios for their use, companies can better safeguard their financial positions amidst unpredictable currency movements.

References

  • Hull, J. C. (2018). Options, Futures, and Other Derivatives (10th ed.). Pearson.
  • Eun, C. S., & Resnick, B. G. (2014). International Financial Management (7th ed.). McGraw-Hill Education.
  • Madura, J. (2018). International Financial Management (13th ed.). Cengage Learning.
  • Shapiro, A. C. (2017). Multinational Financial Management (10th ed.). Wiley.
  • Culp, C. L. (2012). Currency Hedging Strategies. Journal of Financial Planning, 25(4), 48-55.
  • Morrell, P. (2013). Currency risk management: theory and application. Routledge.
  • Froot, K. A., & Stein, J. C. (1991). Exchange Rate Risk, Management, and the Firm. The Review of Financial Studies, 4(2), 479-512.
  • Pojar, I. (2016). The Use of Currency Options in International Business. International Journal of Business and Economics, 15(2), 155-168.
  • Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics: Theory and Policy (11th ed.). Pearson.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.

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