Introduction

Blades, Inc., a U.S. based company wanted to purchase supplies from Japanese supplier with

payment of 12.5 million yen payable on the delivery date. The order has been made two months

ahead of the delivery date. It has two choices. i. Blades inc. will purchase two call options

contract or ii. It will purchase one future contract.

Call Option means an agreement that gives an investor the right (but not the obligation) to buy

a stock, bond, commodity, or other instrument at a specified price within a specific time period.

In the commodity markets, it is considered as a less risky trade. When you buy a call option,

your risk is limited to the price you pay for the call option (premium) plus commissions and fees.

Futures contract means a legally binding arrangement where one party commits to buying an

asset from another party on a specified date in the future, but at a price agreed previously. The

counterparty is obliged to sell the asset at the agreed price and on the agreed date. Because the

price is agreed at the outset the seller (buyer) is protected from a fall (rise) in the price of the

underlying asset in the intervening time period. Initially developed to protect agricultural

producers from unforeseen market fluctuations - hedging. Most traders do not exercise call

options (or convert into a futures contract), instead they will close a call option sometime before

it expires.

So if Blades Inc. chooses two call options they need to pay 6250000 yen for each option, or if it

chooses future contract they need to pay 12.5 million yen. In the case, it indicates that spot rate

will remain same at all the time and that is $.0072 for per yen, but in case of using call options,

exercise price fluctuates over time but not more than 5% above the existing spot rate and

premium would be paid of about 1.5%. In case of purchasing future contract, the future price will

lock into one price that is $0.006912 for per yen.

Foreign exchange rates, at the most basic level, are derived from long-term economic

fundamentals. These variables weigh and measure the value of one currency to another. Over

time, these economic fundamentals and macro-factors will lead to very long-term trends. From

the fundamentalist's perspective, the main factors that affect foreign exchange rates are Interest

rates, Trade balance, Inflation, GDP (Gross Domestic Product), and Employment Situations.

Case Analysis

Question 1: If Blades uses call options to hedge its yen payables, should it use the call option

with the exercise price of $ or the call option with the exercise price of $? Describe the trade off.

Probable Answer: In our case there are 2 call options. For the first call option, the exercise

price is $.00756 and for 2nd call option, exercise price is $.00792 which is higher than the first

call option. Blades Inc. will have to pay no more than 5% above the existing spot rate. Before

of event exercise option premium was 1.57, but now has increased to be 2% which more

expensive than the firm is willing pay. However, in the 2nd call option, the premium is lower

from the exercise price of $ 0.00792. But the exercise price is 10% higher than the spot rate. So,

if the firm chooses to continue this attractive option, this firm has to pay lower premium and also

higher exercise price. If they decide to use this option, their total premium will be 1417.50.

And the amount paid for Yen $ 99.00. Again for the first option the total premium was $1890.00

and amount paid for Yen $94,500. In the summary, if they use the first option, the total cost will

be $ 96,390 ($ 1890 + $ 94500). And in their 2nd call option the total cost will be $ 100417.5 ($

14750+ $ 99,000) which is higher than the first option. If the firm wants to choose call option

between these two options, they can choose first option where there is lower exercise price but

higher premium.

Question 2: Should Blades allow its Yen position to be unhedged? Describe the trade off.

Probable Answer: Blade Inc. has 2 choices – one is call option and another is future contract.

Call option can be unhedged thought the movement of currencies value. It creates new event

relative to before event, when the event faced more uncertainty. In our case, table shows that the

future contract information where the future price will not be affected by uncertainty. Also in

this contract owners are not obliged by this contract relative to the option where owners are

obliged. So that, firm can purchase future contract and lock its future payment value at the same

future price that has before event.

Question 3: Assume there are speculators who attempt to capitalize on their expectation of the

Yen’s movement over the 2 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’s spot rate by the delivery

dates?

Probable Answer: If there are speculators who attempt to capitalize on their expectation on the

Yen’s movement then they want to equal the future spot rate and the future rate. Suppose, if they

expect Yen to appreciate, they will purchase Yen at future rate now. Or they can purchase the

Yen at the future rate in 2 months and sell them at the future spot rate. In this way, if everyone’s

expectation is to appreciate Yen, then all are willing to buy Yen now. Then the amount of Yen

will be increased and there will be upward pressure on the future rate as well as download

pressure on the future spot rate. However, this process will continue up to the equivalent of

future spot rate and future rate will be $ 0.006912.

Question 4: Assume that the firm shares the market consensus of the future yen spot rate. Given

this expectation and given that the firm makes a decision (i.e., option, futures contract, remain

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

Probable answer: based on this question 3 if the speculation decision is made on cost basis and

purchase on future contract where the actual cost will be $86400 which is calculated by:

Future price per unit $.006912

No. of units * 12500000

Total cost = $86400

If they remain unhedge cost will be $86400 which is computed by,

Expected spot rate $.006912

No. of Yen paid * 12500000

Total cost = $86400

This cost will be incurred on the delivery date to purchase Yen can be affected by the movement

of Yen between the delivery date and order date. So that Blade Inc. will prefer to go in future

contract.

Question 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?

Probable answer: we know Yen is more volatile than the other currencies. So that in the future

contract, there will be no cost advantage when the yen currency will fluctuate because in future

contract the price will be paid at the delivery date, so that there is no cost advantage if Yen

depreciate. But if they choose option and remain unhedge there are having the flexibility to buy

Yen at the spot rate.

Remain unhedge:

Spot rate $0.006912

Amounts have to be paid for Yen * 12500000

Total payment = $86400.00

In case of purchasing future contract:

Future price per unit $0.006912

Units in contract * 12500000

Total payment = $86400.00

In case of purchasing two options:

For option 1:

Exercise price $0.0075600

Premium per unit $0.0001512

Total units 6250000

Total costs (($0.0075600+$0.0001512)* 6250000) = $48195

For option 2:

Exercise price $0.0079200

Premium per unit $0.0001134

Total units 6250000

Total costs (($0.0079200+$0.0001134)* 6250000) = $50208.75

Total paid for option 1, exercise price is $.00756.

Total premium $1890

Amounts to be paid for Yen + $86400total paid $88290

In this option they will not exercise the contract as spot rate is less than the exercise rate.

In case of 2nd option, the total amounts have to be paid $87817.50 with exercise price $0.00792,

which is calculated by:

Total premium $1417.50

Amounts have to be paid for Yen + $86400Total paid $87817.50

So this option will not be exercised as the spot rate is less than the exercise rate.

Question 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?

Probable answer: if the standard deviation increases by 2% then the forecasted spot rate will be

$0.007912 (calculated by $.006912+ (2*.0005000))

Cost of remain unhedged will be $98900 (computed by $.007912*12500000)

In case of purchasing future contract if 2% standard deviation increases then costs will be

$86400 because there is no impact of increasing standard deviation on the future price.

In case of purchasing 2 options, for one option cost will be $48195 which is computed by

(($.0075600+$.0001512)*6250000)

For 2nd option costs will be incurred $50209 which is computed by (($.0079200+.0001134)*6250000)

For option 1 exercise price is $0.00756

Total premium $1890

Amounts have to be paid for Yen + $94500Total paid $96390

For option 2 exercise price is $.00792

Total premium $1417.50

Amounts have to be paid for Yen + $98900Total paid $100317.50

In 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be able to generate profit using this option. But in case of 2nd option, spot rate is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc. should not exercise call options rather they should go for future contract.

Conclusion

By analyzing the case study we came to know that, it would be better for Blades Inc. if it purchases future contract rather than two call options. Since selling price is less than the purchasing price, if it exercises two call options company will face loss in future. More than in call option, company is obliged by this contract. There is no advantage to expire it what can be obtained through using future contract. Company can lock into one price in case of purchasing future contract and company is not obliged by it. We have analyzed the case of Blades Inc giving the answer of six questions.

In 1st question we have got the conclusion that if firm chooses any one between two call options, firm should choose 1st call option as because it consists lower exercise price but higher premium in compare to 2nd call option.

In 2nd question we came to the decision that, it is better for firm to go for future contract and lock it’s future payment value at the same future price that has before the event.

In 3rd question our judgment was that the speculators, who want to capitalize on their expectation on yen’s movement, always want to equal the spot rate and the future rate.

In 4th and 5th question our opinion was that Blade Inc. will prefer to go for future contract due to high costs will be incurred in case of purchasing two call options.

Finally, we came to the decision that if historical standard deviation of the yen is about $0.0005 and if 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, then after analyzing, in 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be able to generate profit using this option. But in case of 2nd option, spot rate is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc. should not exercise call options rather they should go for future contracts.