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However, the key is that students have an understanding why firms would consider using these instruments and under what conditions they would use them. Topics to Stimulate Class Discussion 1. Why would a firm ever consider futures contracts instead of forward contracts? 2. What advantage do currency options offer that are not available with futures or forward contracts? 3. What are some disadvantages of currency option contracts? 4. Why do currency futures prices change over time? . Why do currency options prices change over time? 6. Set up several scenarios, and for each scenario, ask students to determine whether it would be better for the firm to purchase (or sell) forward contracts, futures contracts, call option contracts, or put options contracts. Answer to Nikkei Problem Discussion Question: Explain why Nikkei may use forward contracts to hedge committed transactions and use currency options to hedge contracts that are anticipated but not committed.
Why might forward contracts be advantageous for committed transactions, and currency options be advantageous for anticipated transactions? ANSWER: Nikkei may use forward contracts to hedge committed transactions because it would be cheaper to use a forward contract (a premium WOUld be aid on an option contract that has an exercise price equal to the forward rate). Nikkei may use currency options contracts to hedge anticipated transactions because it has more flexibility to let the contract go unexpressed if the transaction does not occur.
Answers to End of Chapter Questions 1. Compare and contrast forward and futures contracts. ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank’s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts. . How can currency futures be used by corporations? How can currency futures be used by speculators? ANSWER: U. S. Reparations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. U. S. Corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 3. What is a currency call option? What is a currency put option?
ANSWER: A currency call option provides the right to purchase a specified currency at a specified price within a specified period Of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. 4. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $. ADD and spot rate is $. 10. State whether your answer is a discount or premium. ANSWER: (FRR-SIR)/SIR – $. 10)/$. 10 x (360/90) =-. 02, or -2%, which reflects a 8% discount. 5. How can a forward contract backfire?
ANSWER: If the spot rate of the foreign currency at the time of the orientations is worth less than the forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward contract has backfired. 6. When would a U. S. Firm consider purchasing a call option in euros for hedging? ANSWER: A call option can hedge a firm’s future payable denominated in euros. It effectively locks in the maximum price to be paid for euros. 7. When would a U. S. Firm consider purchasing a put option on euros for ANSWER: A put option on euros can hedge a U. S. Rim’s future receivables denominated in euros. It effectively locks in the minimum price at which it an exchange euros received. 8. When should a speculator purchase a call option on Australian dollars? ANSWER: Speculators should purchase a call option on Australian dollars if they expect the Australian dollar value to appreciate substantially over the period specified by the option contract. 9. When should a speculator purchase a put option on Australian dollars? ANSWER: Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value to depreciate substantially over the 10.
List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in British pounds (assuming the expiration date and the total dollar value represented by each option are the same for both options)? ANSWER: These factors are listed below: ; The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal. ; The longer the period prior to the expiration date, the greater is the call option value, other things equal. The greater the variability of the currency, the greater is the call option alee, other things equal. The at-the-money call option in euros should have a lower premium because the Euro should have less volatility than the pound. 1 1 -List the factors that affect currency put options and briefly explain the relationship that exists for each. ; The lower the existing spot rate relative to the strike price, the greater is the put option value, other things equal. ; The longer the period prior to the expiration date, the greater is the put ; The greater the variability of the currency, the greater is the put option 12.
Randy Reduced purchased a call option on British pounds for $. 2 per unit. The strike price was $1. 45 and the spot rate at the time the option was exercised was $1. 46. Assume there are 31 , 250 units in a British pound option. What was Rand’s net profit on this option? ANSWER: Profit per unit on exercising the option $. 01 Premium paid per unit= $. 02 Net profit per unit= Net profit per option 31,250 units x (-??$. 01) -?? -$312. 50 13. Alice Diver purchased a put option on British pounds for $. 04 per unit. The strike price was $1. 80 and the spot rate at the time the pound option was exercised was $1. 9. Assume there are 31 ,250 units in a British pound option. What was Lice’s net profit on the option? Profit per unit on exercising the option – $ 21 Premium paid per unit = $. 04 Net profit per unit-?? $. 17 Net profit for one option = 31 , 250 units x $. 17= $5,312. 50 14. Mike Usurer sold a call option on Canadian dollars for $. 01 per unit. The strike price was $. 76 and the spot rate at the time the option was exercised was $. 82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option.
What was Mike’s net profit on the call option? Premium received per unit = $. 01 Amount per unit received from selling C$ = $. 76 Amount per unit paid when purchasing C$ $. 82 -$. 05 Net Profit = 50,000 units x (-3. 05) = -$2,500 15. Brian Tulle sold a put option on Canadian dollars for $. 03 per unit. The strike price was $. 75 and the spot rate at the time the option was exercised was $. 72. Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What Briar’s net profit on the put option?
Premium received per unit = $. 03 Amount per unit received from selling C$ Amount per unit paid for C$ = $. 5 Net profit per unit= $0 $. 72 16. What are the advantages and disadvantages to a U. S. Corporation that uses currency options on euros rather than a forward contract on euros to hedge its exposure in euros? ANSWER: A currency option on euros allows more flexibility since it does not commit one to purchase or sell euros (as is the case with a Euro futures or forward contract). Yet, it does allow the option holder to purchase or sell euros at a locked-in price.
The disadvantage of a Euro option is that the option itself is not free. One must pay a premium for the call option, which is above and beyond the exercise price specified in the contract at which the Euro could be purchased. 17 Assume that the euros spot rate has moved in cycles over time. How might you try to use futures contracts on euros to capitalize on this tendency? How could you determine whether such a strategy would have been profitable in previous periods? ANSWER: Use recent movements in the Euro to forecast future movements. Fifth Euro has been strengthening, purchase futures on euros.
If the Euro has been weakening, sell futures on euros. A strategy profitability can be determined by comparing the amount paid or each contract to the amount for which each contract was sold. 18. Assume that the transactions listed in Column 1 of the following table are anticipated by U. S. Firms that have no other foreign transactions. Place an “X” in the table wherever you see possible ways to hedge each of the transactions. A. Georgetown Co. Plans to purchase Japanese goods denominated in yen. B. Harvard, Inc. , sold goods to Japan, denominated in yen. C.
Yale Corp.. Has a subsidiary in Australia that will be remitting funds to the U. S. Parent. D. Brown, Inc. , needs to pay Off existing loans that are denominated in Canadian dollars. E. Princeton Co. May purchase a company in Japan in the near future (but the deal may not go through). Forward Contract Futures Contraptions Contract Forward Forward Buy Sell Purchase Purchase Purchase Sale FuturesFuturesCalls puts a. X XX d. X XX x 19. Assume that on November 1, the spot rate of the British pound was $1. 58 and the price on a December futures contract was $1. 59.
Assume that the pound depreciated during November so that by November 30 it was worth $1. 51. A) What do you think happened to the futures price over the month of November? Why? ANSWER: The December futures price would have decreased, because it fleets expectations Of the future spot rate as Of the settlement date. If the existing spot rate is $1. 51, the spot rate expected on the December futures settlement date is likely to be near $1. 51 as well. B) If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1?
Explain. ANSWER: You would have sold futures at the existing futures price of $1. 59. Then as the spot rate of the pound declined, the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in the spot market, and fulfill the futures obligation by delivering pounds at the price of $1. 59 per pound. 20. Assume that a March futures contract on Mexican pesos was available in January for $. 09 per unit.
Also assume that forward contracts were available for the same settlement date at a price of $. 092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative activity affect the difference between the forward contract price and the futures price? ANSWER: Speculators could purchase peso futures for $. 09 per unit, and simultaneously sell pesos forward at $. 092 per unit. When the pesos are received (as a result of the futures position) on the settlement date, the speculators would sell the pesos to fulfill their forward contract obligation.