INTERNATIONAL FINANCE

ASSIGNMENT PART-A

Use of Currency Derivative Instruments

Blades, Inc., needs to order supplies 2 months ahead of the delivery date. It is considering an order from a Japa nese supplier that requires a payment of 12.5 million yen payable as of the delivery date. Blades has two choices:

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

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

The futures price on yen has historically exhibited a slight discount from the existing spot rate. However, the firm would like to use currency options to hedge payables in Japanese yen for transactions 2 months in advance. Blades would prefer hedging its yen payable position because it is uncomfortable leaving the posit ion open given the historical volatility of the yen. Nevertheless, the firm would be willing to remain unhedged if the yen becomes more stable someday.

A recent event caused more uncertainty about the yen's future value, although it did not affect the spot rate or the forward or futures rate of the yen. Specific ally, the yen's spot rate was still S.0072, but the option premium for a call option with an exercise price of $.00756 was now S.0001512. An alternative call option is available with an expiration date of 2 months from now it has a premium of $.0001 134 (which is the size of the premium that would have existed for the option desired before the event), but it is for a call option with an exercise price of $.00792.

The table below summarizes the option and futures information available to Blades:

Ben Holt, Blades' chief financial officer (CFO), prefers the flexibility that options offer over forward contracts or futures contracts because he can let the options expire 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 Blades will have to pay no more than 5 perc ent above the existing spot rate for a transaction 2 months beyond its order date, as long as the option prem ium is no more than 1.6 percent of the price it would have to pay per unit when exercising the option.

In general, options on the yen have required a prem ium of about 1.5 percent of the total transaction amount that would be paid if the option is exercised. For example, recently the yen spot rate was 5.0072, and the firm purchased a call option with an exercise price of 5.00756, which is 5 percent above the existing spot rate. The premium for this option was 5.0001134, which is 1.5 percent of the price to be paid per yen if the option is exercised.

As an analyst for Blades, 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 uses call options to hedge its yen payables, should it use the call option with the exercise price of 5.00756 or the call option with the exercise price of $00792? Describe the tradeoff.

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

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 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 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?

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 historical standard deviation of the yen is about 5.0005. 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 5.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm?

BEFORE

EVENT
AFTER

EVENT
Spot rate I I $0072 I 5.0072

Option

Information

ASSIGNMENT PART-B

Assessment of Potential Arbitrage Opportunities

Recall that Blades, a U.S. manufacturer of roller blades, has chosen Thailand as its primary export target for Speedos, Blades' primary product. Moreover, Blades' primary customer in Thailand, Entertainment Prod ucts, has committed itself to purchase 180,000 Speedos annually for the next 3 years at a fixed price denominated in baht, Thailand's currency. Because of quality and cost considerations, Blades also imports some of the rubber and plastic components needed to manufacture Speedos from Thailand.

Lately, Thailand has experienced weak economic growth and political uncertainty. As investors lost conf idence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the count ry. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange mark et, which put downward pressure on the baht's value. As foreign investors continued to withdraw their funds from Thailand, the baht's value continued to deterior ate. Since Blades has net cash flows in baht resulting from its exports to Thailand, a deterioration in the baht's value will affect the company negatively.

Ben Holt, Blades' CFO, would like to ensure that the spot and forward rates Blades' bank has quoted are reasonable. If the exchange rate quotes are reasona ble, then arbitrage will not be possible. If the quotat ions are not appropriate, however, arbitrage may be possible. Under these conditions, Holt would like Blades to use some form of arbitrage to take advant age of possible mispricing in the foreign exchange market Although Blades is not an arbitrageur, Holt believes that arbitrage opportunities could offset the negative impact resulting from the baht's depreciat ion, which would otherwise seriously affect Blades' profit margins.

Determine whether the cross exchange rate between the Thai baht and Japanese yen is appropriate. If it is not appropriate, determine the profit you could genera te for Blades by withdrawing $100,000 from Blades' checking account and engaging in triangular arbitrage before the rates are adjusted.

3. Ben Holt has obtained several forward contract quotations for the Thai baht to determine whether covered interest arbitrage may be possible. He was quoted a forward rate of $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227. Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular arbitrage, requires an investment of funds. Thus, he Holt has identified three arbitrage opportunities as profitable and would like to know which one of them is the most profitable. Thus, he has asked you, Blades' financ ial analyst, to prepare an analysis of the arbitrage opport unities he has identified. This would allow Holt to assess the profitability of arbitrage opportunities very quiddy.

1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate quotations from two banks in Thailand: Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask prices of Thai baht for each bank are displayed in the table below:

Determine whether the foreign exchange quotations are appropriate. If they are not appropriate, determine the profit you could generate by withdrawing $100,000 from Blades' checking account and engaging in arbit rage before the rates are adjusted.

2. Besides the bid and ask quotes for the Thai baht provided in the previous question, Minzu Bank has provided the following quotations for the U.S. dollar and the Japanese yen: would like to be able to estimate the dollar profit resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit.

Determine whether the forward rate is priced approp riately. if it is not priced appropriately, determine the profit you could generate for Blades by withdrawing $100,000 from Blades' checking account and engaging in covered interest arbitrage. Measure the profit as the excess amount above what you could generate by investing in the U.S. money market.

4. Why are arbitrage opportunities likely to disappear soon after they have been discovered? To illustrate your answer, assume that covered interest arbitrage involving the immediate purchase and forward sale of baht is possible. Discuss how the baht's spot and forward rates would adjust until covered interest arbitrage is no longer possible. What is the resulting equilibrium state called?