Question 4

a. Assume that the transactions listed in the first column of the table below are anticipated by Malaysian firms that have no other foreign transactions. Place an ‘X’ in the table where you see possible ways to hedge each of the transactions.

Situation	Forward Contract	Futures Contract	Options Contract
Forward Purchase	Forward Sale	Buy Futures	Sell Futures	Purchase a Call	Purchase a Put
i. Iskandar Sdn. Bhd. Plans to purchase Japanese goods denominated in yen
ii. Kannan Sdn. Bhd. Will sell goods to Japan, denominated in Yen
iii. Petronas has a subsidiary in Australia that will be remitting funds to the Malaysian parent company.
iv. Cheng Sdn. Bhd. Needs to pay off existing loans that are denominated in Canadian dollars.
v. Azizul Sdn. Bhd. May purchase a company in Japan in the near future (but the deal may not go through).

ANSWER

Situation	Forward Contract	Futures Contract	Options Contract
Forward Purchase	Forward Sale	Buy Futures	Sell Futures	Purchase a Call	Purchase a Put
i.	X		X		X
ii.		X		X		X
iii.		X		X		X
iv.	X		X		X
v.					X

QUESTION 5

At the start of January 2013, a computer manufacturer in UK places an order with a processor supplier from the USA. The value of the order is $1 million. The USA supplier and the UK manufacturer agree that full payment will take place in 90 days and that the account will be settled in US dollars. The current spot exchange on the London currency exchange is £1 = $1.95 and the company is offered an ‘at the money’ option contract with the premium costing £8,000.

Required

i. In this scenario, explain fully the currency price movement that is feared by the UK manufacturer with example.

ii. Explain what appropriate currency option hedge the UK manufacturer should employ.

iii. Evaluate the outcome of the options hedge, if by the end of March the currency prices have changed to: (a) £1 = $1.70 (b) £1 = $2.30

ANSWER

i. The current spot exchange rate is £1 = $1.95 and therefore if the exchange rate does not change, in 90 days the manufacturer will have to pay 1,000,000/1.95= £512,820.51. If the dollar strengthens against the pound, and the exchange rate becomes £1 = $ 1.75 in 90 days, then the manufacturer will have to pay 1,000,000/1.75= £571,428.71. Therefore if the dollar strengthens, then the manufacturer will have to pay more in pounds. This is the currency price movement that is feared by the manufacturer.

ii. The UK importer can purchase dollar call option. It can also take long position on futures or forward contracts for dollars

iii. Currency prices changes to £1 = $1.70.

Since the US dollar has strengthened the company will exercise the option. Therefore at the end of March even though the spot exchange rate is £1 = $1.70, the company, by exercising the option buys $1.0 million at a rate of £1 = $1.95 by paying £512,820.51. Therefore the gain to the company is given by £588,235.29 - £512,820.51 - £8,000 = £67,414.78

Exchange rate changes to £1 = $2.30

Since the US dollar has weakened the option will not be exercised because it is more profitable to engage in a spot transaction. At the end of March the company will pay £434,782.60 ($1,000,000/2.30) in order to settle the contract. Compared to the anticipated payment of £512,820.51 at the start of January, the company by paying less makes a profit of £70,037.91 (£512,820.51 - £434,782.60- £8,000).

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