Blades Inc. needs to order supplies two months ahead of the delivery date. It is considering an order from a Japanese supplier that requires a payment of 12.5 million yen payable as of the delivery date and so the company has two choices

Purchase two call options contracts (since each option contract represent 6,250,000 yen)

Purchase one futures contract (which represents the 12.5 million yen).

The CFO prefers the flexibility that options offer over forward contracts because he can let the options expires if the yen depreciates. He would like to use an exercise price that is about 5 percent above the existing spot rate to ensure that his company will have to pay no more than 5% above the existing spot rate for a transaction two months beyond its order date, as long as the option premium is no more than 1.6% of the price it would have to pay per unit when exercising the option.

In general, options on the yen have required a premium of about 1.5% of the total transaction amount that would be paid if the option is exercised. For example, recently the yen spot rate was $0.0072, and the firm purchased a call option with an exercise price of $0.00756, which is 5% above the existing spot rate. The premium for this option was $0.0001134, which is 1.5% of the price to be paid per yen if the option is exercised.

A recent event caused more uncertainty about the yen's future value, although it did not affect the spot rate or the forward or future rate of the yen.

Specifically, the yen's spot rate was still $0.0072, but the option premium for a call option with an exercise price of $0.00756 was now $0.0001134 (which is the size of the premium that would be exercised for the option desired before the event), but it is for a call option with an exercise price of $0.00792.

The table below summarizes the option and future option and futures information available to the company.

As analyst for the company, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of questions 4 and 6.

1. If Blades, Inc uses call options to hedge its yen payables, should it use the call option with the exercise price of $0.00756 or the call option price of $0.00792? Describe the tradeoff.

2. Should the company allow its yen position to be unhedged? Describe the tradeoff

3. Assume there are speculators who attempt to capitalize on their expectations of the yen's movement over the two 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 spot rate by the delivery date? (Your answer should consist of one number)

4. Assume that the firm shares the market consensus of the future yen spot rate given this expectations and given that the firm makes a decision (i.e. option, future contract, remain unhedged) purely on a cost basis, what would be its optimal choice?

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?

6. Now assume that you have determined that the historic standard deviation of the yen is about $0.0005. Based on your assessment, you believed it highly unlikely that the future spot rate will be more than 2 standard deviations above the expected spot rate by the delivery date. Also assume that the future price remains at its current level of $0.006912. Based on these expectations of the future spot rate, what is the optimum hedge for the firm?

Before event After event

Spot rate $.0072 $.0072 $.0072

Optional information

Exercise price ($) $.00756 $.00756 $.00792

Exercise price (%above spot) 5% 5% 10%

Option premium per Yen ($) $.0001134 $.0001512 $.0001134

Option premium % of exercised prices 1.5% 2% 1.5%

Total premium ($) $1,417.50 $1,890.00 $1,417.50

Amount paid for yen if option is exercised (not including premium $) $94,500 $94,000 $99,000

Future contract information

Future price $0.006912 $0.006912

Purchase two call options contracts (since each option contract represent 6,250,000 yen)

Purchase one futures contract (which represents the 12.5 million yen).

The CFO prefers the flexibility that options offer over forward contracts because he can let the options expires if the yen depreciates. He would like to use an exercise price that is about 5 percent above the existing spot rate to ensure that his company will have to pay no more than 5% above the existing spot rate for a transaction two months beyond its order date, as long as the option premium is no more than 1.6% of the price it would have to pay per unit when exercising the option.

In general, options on the yen have required a premium of about 1.5% of the total transaction amount that would be paid if the option is exercised. For example, recently the yen spot rate was $0.0072, and the firm purchased a call option with an exercise price of $0.00756, which is 5% above the existing spot rate. The premium for this option was $0.0001134, which is 1.5% of the price to be paid per yen if the option is exercised.

A recent event caused more uncertainty about the yen's future value, although it did not affect the spot rate or the forward or future rate of the yen.

Specifically, the yen's spot rate was still $0.0072, but the option premium for a call option with an exercise price of $0.00756 was now $0.0001134 (which is the size of the premium that would be exercised for the option desired before the event), but it is for a call option with an exercise price of $0.00792.

The table below summarizes the option and future option and futures information available to the company.

As analyst for the company, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of questions 4 and 6.

1. If Blades, Inc uses call options to hedge its yen payables, should it use the call option with the exercise price of $0.00756 or the call option price of $0.00792? Describe the tradeoff.

2. Should the company allow its yen position to be unhedged? Describe the tradeoff

3. Assume there are speculators who attempt to capitalize on their expectations of the yen's movement over the two 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 spot rate by the delivery date? (Your answer should consist of one number)

4. Assume that the firm shares the market consensus of the future yen spot rate given this expectations and given that the firm makes a decision (i.e. option, future contract, remain unhedged) purely on a cost basis, what would be its optimal choice?

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?

6. Now assume that you have determined that the historic standard deviation of the yen is about $0.0005. Based on your assessment, you believed it highly unlikely that the future spot rate will be more than 2 standard deviations above the expected spot rate by the delivery date. Also assume that the future price remains at its current level of $0.006912. Based on these expectations of the future spot rate, what is the optimum hedge for the firm?

Before event After event

Spot rate $.0072 $.0072 $.0072

Optional information

Exercise price ($) $.00756 $.00756 $.00792

Exercise price (%above spot) 5% 5% 10%

Option premium per Yen ($) $.0001134 $.0001512 $.0001134

Option premium % of exercised prices 1.5% 2% 1.5%

Total premium ($) $1,417.50 $1,890.00 $1,417.50

Amount paid for yen if option is exercised (not including premium $) $94,500 $94,000 $99,000

Future contract information

Future price $0.006912 $0.006912

## This question was asked on May 01, 2010.

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